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Chapter 14
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
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
project’s 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.
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
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:
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.
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.
Payback = 8 + ($75,000 ÷ $100,000) years
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. Bach’s 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
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 part—especially 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.
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.
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
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
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
45. future value × discount factor = present value
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.
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%
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.
53. A company’s 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.
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. Amount: ($31,000) $6,800 $7,100 $7,300 $7,000 $7,000 $7,100 $7,200
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
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)
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)
Profitability index = ($160,000 + $27,781) ÷ $160,000 = 1.17
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
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
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%,
68. a. Project name NPV PVI IRR
b. It exceeds the highest rate provided in the table. By computer it is 23.29%.
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
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
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
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
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.
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
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:
b. The company should accept the proposal since the NPV is
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.
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
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
