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Chapter 12

Risk and
Refinements in
Capital
Budgeting

Copyright 2012 Pearson Prentice Hall.

Learning Goals
LG1 Understand the importance of recognizing risk in the
analysis of capital budgeting projects.
LG2 Discuss risk and cash inflows, scenario analysis, and
simulation as behavioral approaches for dealing with
risk.
LG3 Review the unique risks that multinational companies
face.

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Learning Goals (cont.)


LG4 Describe the determination and use of risk-adjusted
discount rates (RADRs), portfolio effects, and the
practical aspects of RADRs.
LG5 Select the best of a group of unequal-lived, mutually
exclusive projects using annualized net present values
(ANPVs).
LG6 Explain the role of real options and the objective and
procedures for selecting projects under capital
rationing.
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Introduction to Risk in Capital


Budgeting
Thus far, we have assumed that all investment projects
have the same level of risk as the firm.
In other words, we assumed that all projects are equally
risky, and the acceptance of any project would not change
the firms overall risk.
In actuality, these situations are rareprojects are not
equally risky, and the acceptance of a project can affect
the firms overall risk.

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Table 12.1 Cash Flows and NPVs


for Bennett Companys Projects

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Behavioral Approaches for Dealing


with Risk: Risk and Cash Inflows
Behavioral approaches can be used to get a feel for the
level of project risk, whereas other approaches try to
quantify and measure project risk.
Risk (in capital budgeting) refers to the uncertainty
surrounding the cash flows that a project will generate or,
more formally, the degree of variability of cash flows.
In many projects, risk stems almost entirely from the cash
flows that a project will generate several years in the
future, because the initial investment is generally known
with relative certainty.
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Behavioral Approaches for Dealing with


Risk: Risk and Cash Inflows (cont.)
Treadwell Tire Company, a tire retailer with a 10% cost of
capital, is considering investing in either of two mutually
exclusive projects, A and B. Each requires a $10,000 initial
investment, and both are expected to provide constant
annual cash inflows over their 15-year lives. For either
project to be acceptable its NPV must be greater than zero.

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Behavioral Approaches for Dealing with


Risk: Risk and Cash Inflows (cont.)

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Behavioral Approaches for Dealing


with Risk: Scenario Analysis
Scenario analysis is a behavioral approach that uses
several possible alternative outcomes (scenarios), to
obtain a sense of the variability of returns, measured here
by NPV.
In capital budgeting, one of the most common scenario
approaches is to estimate the NPVs associated with
pessimistic (worst), most likely (expected), and optimistic
(best) estimates of cash inflow.
The range can be determined by subtracting the
pessimistic-outcome NPV from the optimistic-outcome
NPV.
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Table 12.2 Scenario Analysis of


Treadwells Projects A and B

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Behavioral Approaches for


Dealing with Risk: Simulation
Simulation is a statistics-based behavioral approach that
applies predetermined probability distributions and random
numbers to estimate risky outcomes.

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Figure 12.1 NPV Simulation

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Focus on Practice
The Monte Carlo Method: The Forecast Is for Less Uncertainty
To combat uncertainty in the decision-making process, some companies use a
Monte Carlo simulation program to model possible outcomes.
A Monte Carlo simulation program randomly generates values for uncertain
variables over and over to simulate a model.
The simulation then requires project practitioners to develop low, high, and
most likely cost estimates along with correlation coefficients.
One of the problems with using a Monte Carlo program is the difficulty of
establishing the correct input ranges for the variables and determining the
correlation coefficients for those variables.
A Monte Carlo simulation program requires the user to first build an Excel
spreadsheet model that captures the input variables for the proposed project.
What issues and what benefits can the user derive from this process?

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International Risk
Considerations
Exchange rate risk is the danger that an unexpected
change in the exchange rate between the dollar and the
currency in which a projects cash flows are denominated
will reduce the market value of that projects cash flow.
In the short term, much of this risk can be hedged by
using financial instruments such as foreign currency
futures and options.
Long-term exchange rate risk can best be minimized by
financing the project in whole or in part in the local
currency.
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Matter of Fact
A 2001 survey of Chief Financial Officers (CFOs) found
that more than 40% of the CFOs felt that it was important to
adjust an investment projects cash flows or discount rates to
account for foreign exchange risk.

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International Risk
Considerations (cont.)
Political risk is much harder to protect against. Firms that make
investments abroad may find that the host-country government can
limit the firms ability to return profits back home. Governments
can seize the firms assets, or otherwise interfere with a projects
operation.
The difficulties of managing political risk after the fact make it
even more important that managers account for political risks
before making an investment.
They can do so either by adjusting a projects expected cash
inflows to account for the probability of political interference or by
using risk-adjusted discount rates in capital budgeting formulas.
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International Risk
Considerations (cont.)
Other special issues relevant for international capital
budgeting include:
Taxes
Transfer pricing
Strategic, rather than financial, considerations

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Risk-Adjusted Discount Rates


Risk-adjusted discount rates (RADR) are rates of return
that must be earned on a given project to compensate the
firms owners adequatelythat is, to maintain or improve
the firms share price.

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Personal Finance Example


Talor Namtig is considering investing $1,000 in either of
two stocksA or B. She plans to hold the stock for exactly
5 years and expects both stocks to pay $80 in annual end-ofyear cash dividends. At the end of the year 5 she estimates
that stock A can be sold to net $1,200 and stock B can be
sold to net $1,500. Her research indicates that she should
earn an annual return on an average risk stock of 11%.
Because stock B is considerably riskier, she will require a
14% return from it. Talor makes the following calculations
to find the risk-adjusted net present values (NPVs) for the
two stocks:
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Personal Finance Example


(cont.)

Although Talors calculations indicate that both stock


investments are acceptable (NPVs > $0), on a risk-adjusted
basis, she should invest in Stock B because it has a higher
NPV.
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Risk-Adjusted Discount Rates:


Review of CAPM
Using beta, bj, to measure the relevant risk of any asset j, the
CAPM is
rj = RF + [bj (rm RF)]
where
rj
RF
bj
rm

=
=
=
=

required return on asset j


risk-free rate of return
beta coefficient for asset j
return on the market portfolio of assets

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Figure 12.2
CAPM and SML

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Risk-Adjusted Discount Rates:


Using CAPM to Find RADRs (cont.)
Figure 12.2 shows two projects, L and R.
Project L has a beta, bL, and generates an internal rate of return,
IRRL. The required return for a project with risk bL is rL.
Because project L generates a return greater than that required (IRR L > rL),
project L is acceptable.
Project L will have a positive NPV when its cash inflows are discounted at its
required return, rL.

Project R, on the other hand, generates an IRR below that required


for its risk, bR (IRRR < rR).
This project will have a negative NPV when its cash inflows are discounted at
its required return, rR.
Project R should be rejected.

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Focus on Ethics
Ethics and the Cost of Capital
On April 20, 2010 the Deepwater Horizon, an offshore drilling rig
operated by Transocean Ltd. on behalf of BP, exploded and
eventually sank in the Gulf of Mexico, killing 11 people.
To make matters worse, oil began spewing into the Gulf.
By June 2010, BPs stock price was 50% below pre-crisis levels
and the companys bonds traded at levels comparable to junk rated
companies.
Is the ultimate goal of the firm, to maximize the wealth of the
owners for whom the firm is being operated, ethical?
Why might ethical companies benefit from a lower cost of capital
than less ethical companies?

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Risk-Adjusted Discount Rates:


Applying RADRs
Bennett Company wishes to apply the Risk-Adjusted
Discount Rate (RADR) approach to determine whether to
implement Project A or B. In addition to the data presented
earlier, Bennetts management assigned a risk index of
1.6 to project A and 1.0 to project B as indicated in the
following table. The required rates of return associated with
these indexes are then applied as the discount rates to the
two projects to determine NPV.

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Risk-Adjusted Discount Rates:


Applying RADRs (cont.)

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Figure 12.3a Calculation of NPVs for Bennett


Companys Capital Expenditure Alternatives
Using RADRs

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Figure 12.3b Calculation of NPVs for Bennett


Companys Capital Expenditure Alternatives
Using RADRs

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Risk-Adjusted Discount Rates:


Applying RADRs (cont.)
Project A

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Project B

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Risk-Adjusted Discount Rates:


Applying RADRs (cont.)

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Risk-Adjusted Discount Rates:


Portfolio Effects
As noted earlier, individual investors must hold
diversified portfolios because they are not rewarded for
assuming diversifiable risk.
Because business firms can be viewed as portfolios of
assets, it would seem that it is also important that they too
hold diversified portfolios.
Surprisingly, however, empirical evidence suggests that
firm value is not affected by diversification.
In other words, diversification is not normally rewarded
and therefore is generally not necessary.
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Risk-Adjusted Discount Rates:


Portfolio Effects (cont.)
It turns out that firms are not rewarded for diversification
because investors can do so themselves.
An investor can diversify more readily, easily, and
costlessly simply by holding portfolios of stocks.

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Table 12.3 Bennett Companys


Risk Classes and RADRs

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Risk-Adjusted Discount Rates:


RADRs in Practice (cont.)
Assume that the management of Bennett Company decided to use risk
classes to analyze projects and so placed each project in one of four
risk classes according to its perceived risk. The classes ranged from I
for the lowest-risk projects to IV for the highest-risk projects.
The financial manager of Bennett has assigned project A to class III
and project B to class II. The cash flows for project A would be
evaluated using a 14% RADR, and project Bs would be evaluated
using a 10% RADR. The NPV of project A at 14% was calculated in
Figure 12.3 to be $6,063, and the NPV for project B at a 10% RADR
was shown in Table 12.1 to be $10,924.
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Capital Budgeting Refinements:


Comparing Projects With Unequal Lives
The financial manager must often select the best of a
group of unequal-lived projects.
If the projects are independent, the length of the project
lives is not critical.
But when unequal-lived projects are mutually exclusive,
the impact of differing lives must be considered because
the projects do not provide service over comparable time
periods.

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

The AT Company, a regional cable-TV firm, is evaluating


two projects, X and Y. The projects cash flows and resulting
NPVs at a cost of capital of 10% is given below.

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

Project X

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Project Y

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

Ignoring the difference in their useful lives, both projects are


acceptable (have positive NPVs). Furthermore, if the
projects were mutually exclusive, project Y would be
preferred over project X. However, it is important to
recognize that at the end of its 3 year life, project Y must be
replaced, or renewed.

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)
The annualized net present value (ANPV) approach is an approach
to evaluating unequal-lived projects that converts the net present value
of unequal-lived, mutually exclusive projects into an equivalent
annual amount (in NPV terms).
Step 1

Calculate the net present value of each project j, NPVj,


over its life, nj, using the appropriate cost of capital, r.

Step 2

Convert the NPVj into an annuity having life nj. That is,
find an annuity that has the same life and the same NPV
as the project.

Step 3

Select the project that has the highest ANPV.

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

By using the AT Company data presented earlier for projects


X and Y, we can apply the three-step ANPV approach as
follows:
Step 1 The net present values of projects X and Y
discounted at 10%as calculated in the
preceding example for a single purchase of each
assetare
NPVX = $11,277.24 (table value = $11,248)
NPVY = $19,013.27 (table value = $18,985)
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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

Step 2 In this step, we want to convert the NPVs from


Step 1 into annuities. For project X, we are
trying to find the answer to the question, what 3year annuity (equal to the life of project X) has a
present value of $11,248 (the NPV of project
X)? Likewise, for project Y we want to know
what 6-year annuity has a present value of
$18,985. Once we have these values, we can
determine which project, X or Y, delivers a
higher annual cash flow on a present value
basis.
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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

Project X

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Project Y

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

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Capital Budgeting Refinements: Comparing


Projects With Unequal Lives (cont.)

Step 3 Reviewing the ANPVs calculated in Step 2, we


can see that project X would be preferred over
project Y. Given that projects X and Y are
mutually exclusive, project X would be the
recommended project because it provides the
higher annualized net present value.

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Recognizing Real Options


Real options are opportunities that are embedded in capital
projects that enable managers to alter their cash flows and
risk in a way that affects project acceptability (NPV).
Also called strategic options.

By explicitly recognizing these options when making capital


budgeting decisions, managers can make improved, more
strategic decisions that consider in advance the economic
impact of certain contingent actions on project cash flow
and risk.
NPVstrategic = NPVtraditional + Value of real options
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Table 12.4
Major Types of Real Options

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Recognizing Real Options


(cont.)
Assume that a strategic analysis of Bennett Companys
projects A and B finds no real options embedded in Project
A but two real options embedded in B:
1. During its first two years, B would have downtime that results
in unused production capacity that could be used to perform
contract manufacturing;
2. Project Bs computerized control system could control two
other machines, thereby reducing labor costs.

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Recognizing Real Options


(cont.)
Bennetts management estimated the NPV of the contract
manufacturing over the two years following implementation of project
B to be $1,500 and the NPV of the computer control sharing to be
$2,000. Management felt there was a 60% chance that the contract
manufacturing option would be exercised and only a 30% chance that
the computer control sharing option would be exercised. The
combined value of these two real options would be the sum of their
expected values.
Value of real options for project B
= (0.60 $1,500) + (0.30 $2,000)
= $900 + $600 = $1,500
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Recognizing Real Options


(cont.)
Adding the $1,500 real options value to the traditional NPV of
$10,924 for project B, we get the strategic NPV for project B.
NPVstrategic = $10,924 + $1,500 = $12,424
Bennett Companys project B therefore has a strategic NPV of
$12,424, which is above its traditional NPV and now exceeds project
As NPV of $11,071. Clearly, recognition of project Bs real options
improved its NPV (from $10,924 to $12,424) and causes it to be
preferred over project A (NPV of $12,424 for B > NPV of $11,071 for
A), which has no real options embedded in it.

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Capital Rationing
Firms often operate under conditions of capital rationing
they have more acceptable independent projects than
they can fund.
In theory, capital rationing should not existfirms should
accept all projects that have positive NPVs.
However, in practice, most firms operate under capital
rationing.
Generally, firms attempt to isolate and select the best
acceptable projects subject to a capital expenditure budget
set by management.
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Capital Rationing (cont.)


The internal rate of return approach is an approach to
capital rationing that involves graphing project IRRs in
descending order against the total dollar investment to
determine the group of acceptable projects.
The graph that plots project IRRs in descending order
against the total dollar investment is called the
investment opportunities schedule (IOS).
The problem with this technique is that it does not
guarantee the maximum dollar return to the firm.

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Capital Rationing (cont.)


Tate Company, a fast growing plastics company with a cost
of capital of 10%, is confronted with six projects competing
for its fixed budget of $250,000.

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Figure 12.4 Investment


Opportunities Schedule

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Capital Rationing (cont.)


The net present value approach is an approach to capital
rationing that is based on the use of present values to
determine the group of projects that will maximize
owners wealth.
It is implemented by ranking projects on the basis of IRRs
and then evaluating the present value of the benefits from
each potential project to determine the combination of
projects with the highest overall present value.

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Table 12.5 Rankings for Tate


Company Projects

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Review of Learning Goals


LG1 Understand the importance of recognizing risk in the
analysis of capital budgeting projects.
The cash flows associated with capital budgeting projects
typically have different levels of risk, and the acceptance of
a project generally affects the firms overall risk. Thus it is
important to incorporate risk considerations in capital
budgeting.

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Review of Learning Goals


(cont.)
LG2 Discuss risk and cash inflows, scenario analysis, and
simulation as behavioral approaches for dealing with
risk.
Risk in capital budgeting is the degree of variability of cash
flows, which for conventional capital budgeting projects
stems almost entirely from net cash flows. Finding the
breakeven cash inflow and estimating the probability that it
will be realized make up one behavioral approach for
assessing capital budgeting risk. Scenario analysis is another
behavioral approach for capturing the variability of cash
inflows and NPVs. Simulation is a statistically based
approach that results in a probability distribution of project
returns.

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Review of Learning Goals


(cont.)
LG3 Review the unique risks that multinational companies
face.
Although the basic capital budgeting techniques are the
same for multinational and purely domestic companies,
firms that operate in several countries must also deal with
exchange rate and political risks, tax law differences,
transfer pricing, and strategic issues.

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Review of Learning Goals


(cont.)
LG4 Describe the determination and use of risk-adjusted
discount rates (RADRs), portfolio effects, and the
practical aspects of RADRs.
The risk of a project whose initial investment is known with
certainty is embodied in the present value of its cash
inflows, using NPV. Two opportunities to adjust the present
value of cash inflows for risk existadjust the cash inflows
or adjust the discount rate. Because adjusting the cash
inflows is highly subjective, adjusting discount rates is
more popular. RADRs use a market-based adjustment of the
discount rate to calculate NPV.
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Review of Learning Goals


(cont.)
LG5 Select the best of a group of unequal-lived, mutually
exclusive projects using annualized net present values
(ANPVs).
The ANPV approach is the most efficient method of
comparing ongoing, mutually exclusive projects that have
unequal usable lives. It converts the NPV of each unequallived project into an equivalent annual amountits ANPV.

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Review of Learning Goals


(cont.)
LG6 Explain the role of real options and the objective and
procedures for selecting projects under capital rationing.
Real options are opportunities that are embedded in capital projects
and that allow managers to alter their cash flow and risk in a way
that affects project acceptability (NPV). By explicitly recognizing
real options, the financial manager can find a projects strategic
NPV.
Capital rationing exists when firms have more acceptable
independent projects than they can fund. The two basic approaches
for choosing projects under capital rationing are the internal rate of
return approach and the net present value approach. The NPV
approach better achieves the objective of using the budget to
generate the highest present value of inflows.

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Chapter Resources on
MyFinanceLab
Chapter Cases
Group Exercises
Critical Thinking Problems

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Integrative Case:
Lasting Impressions Company
Lasting Impressions (LI) Companys general manager has
proposed the purchase of one of two large, six-color presses
designed for long, high-quality runs. The purchase of a new
press would enable LI to reduce its cost of labor and
therefore the price to the client, putting the firm in a more
competitive position. The key financial characteristics of the
old press and of the two proposed presses are summarized in
what follows.

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Integrative Case: Lasting


Impressions Company (cont.)
Press A This highly automated press can be purchased for
$830,000 and will require $40,000 in installation costs. It will
be depreciated under MACRS using a 5-year recovery period.
At the end of the 5 years, the machine could be sold to net
$400,000 before taxes. If this machine is acquired, it is
anticipated that the following current account changes would
result:
Cash: +$25,400
Accounts receivable: +$120,000
Inventories: $20,000
Accounts payable: +$35,000

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Integrative Case: Lasting


Impressions Company (cont.)
Press B This press is not as sophisticated as press A. It costs
$640,000 and requires $20,000 in installation costs. It will
be depreciated under MACRS using a 5-year recovery
period. At the end of 5 years, it can be sold to net $330,000
before taxes. Acquisition of this press will have no effect on
the firms net working capital investment.

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Integrative Case: Lasting


Impressions Company (cont.)
The firm estimates that its earnings before depreciation,
interest, and taxes with the old press and with press A or
press B for each of the 5 years would be as shown in Table
1. The firm is subject to a 40% tax rate. The firms cost of
capital, r, applicable to the proposed replacement is 14%.

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Table 1. Earnings Before Depreciation,


Interest, and Taxes for Lasting Impressions
Companys Presses

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Integrative Case: Lasting


Impressions Company (cont.)
a. For each of the two proposed replacement presses,
determine:
1. Initial investment.
2. Operating cash inflows. (Note: Be sure to consider the
depreciation in year 6.)
3. Terminal cash flow. (Note: This is at the end of year 5.)

b. Using the data developed in part a, find and depict on a


time line the relevant cash flow stream associated with
each of the two proposed replacement presses, assuming
that each is terminated at the end of 5 years.
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Integrative Case: Lasting


Impressions Company (cont.)
c. Using the data developed in part b, apply each of the
following decision techniques:
1. Payback period. (Note: For year 5, use only the operating cash
inflowsthat is, exclude terminal cash flowwhen making
this calculation.)
2. Net present value (NPV).
3. Internal rate of return (IRR).

d. Draw net present value profiles for the two replacement


presses on the same set of axes, and discuss conflicting
rankings of the two presses, if any, resulting from use of
NPV and IRR decision techniques.
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Integrative Case: Lasting


Impressions Company (cont.)
e.

Recommend which, if either, of the presses the firm


should acquire if the firm has (1) unlimited funds or
(2) capital rationing.

f.

What is the impact on your recommendation of the fact


that the operating cash inflows associated with press A
are characterized as very risky in contrast to the lowrisk operating cash inflows of press B?

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