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CHAPTER 20: CAPITAL BUDGETING

QUESTIONS
20-1 Capital budgeting decisions (a) are long-term in nature (i.e., they affect
profitability and cash flows for many years into the future), and (b) involve
substantial amounts of investment funds (capital). Because of these, formal
models that focus on discounted after-tax flows are needed for investmentanalysis purposes.
20-2 As members of managerial decision-making teams, accountants can add value
to the capital budgeting process in at least four ways: (1) ensuring linkage
between the capital budgeting process and the organizations master budget; (2)
ensuring linkage to the strategic plans of the organization (e.g., integrating capital
budgeting into an organizations Balanced Scorecard); (3) generating relevant
cash-flow estimates for capital budgeting decision models; and (4) participating in
the conduct of post-audits for capital investments. The first area relates to the
planning, the second and fourth areas relate to the control function of
management, while the third area relates to the decision-making function of
management.
20-3 The analytic hierarchy process (AHP) is one of several multi-criteria decisionmaking techniques, that is, decision models that include more than a single
decision criterion. As such, the model can incorporate both financial and
nonfinancial (strategic) decision criteria, weighted according to managerial
preferences. Dedicated software (e.g., Expert Choice) is available to guide the
process of determining the weights associated with various decision criteria and
the selection of investment projects based on these criteria. The AHP has been
applied successfully to numerous decision contexts.
20-4 Project Initiation:
Purchase price of equipment
Transportation/insurance costs for new equipment
Installation costs
Training costs
Investment tax credits (if applicable)
Gross proceeds from sale of old asset (if applicable)
Tax-savings associated with deductibility of loss on sale of old asset (if
applicable)
Project Operation:
Inflows: After-tax fees from patients/third-party payers (insurance companies,
the government)
Inflows: Income-tax savings due to depreciation deductions
Outflows: After-tax salary, wages, and benefits for additional professional
medical staff including: Physicians, Technicians, Nurses, and Clerks
Outflows: After-tax operating expenses for the scanner, such as Utilities,
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Supplies, and Maintenance expenses


Project Disposal:
After-tax proceeds from sale/disposal of asset
After-tax disposal costs
20-5 After 20 years of operation, the company needs to ensure that there is no
residual effect on the environment before abandoning the chemical factory.
Restoration of the site to remove any environmental effect to the neighborhood
the factory might have caused over the years is the most critical step the firm
needs to take. Very likely it is also among the most expensive processes and as
such should be included in any capital budgeting decision model used to
evaluate the proposed investment.
20-6

Income-tax effects represent changes (i.e., increases or decreases) to the


income-tax liability of the firm. Tax effects of a decision to acquire new factory
equipment may include:
Decreases in income taxes because of the deductibility of depreciation
expenses of the factory equipment.
Increases in tax payments for taxable gains (or decreases in tax payments for
tax-deductible losses) on disposal of the old equipment.
Increases in tax payments for taxable gains (or decreases in tax payments for
tax-deductible losses) on disposal of the new assets at the end of their useful
lives.
Investment tax credit (if applicable).
Income-tax shield associated with any equipment-related operating expenses
(e.g., maintenance).

20-7 Book value of an existing asset is, by itself, irrelevant in terms of the decision to
replace the asset. However, any taxable gain or loss recognized on the disposal
of an asset is partly a function of the tax basis of the asset. Such gains or losses
affect the tax payments, and therefore cash flows, of the firm. These cash-flow
effects are relevant in capital budgeting decisions.
20-8 Among the limitations of the payback period decision model are its failure to
consider a projects total profitability over its useful life and failure to incorporate
the time value of money. The present value payback period model considers the
time value of money. However, it too fails to consider the profitability of a project
over the projects entire lifetime. Critics maintain, therefore, that the use of this
method for investment analysis may bias decisions away from long-term,
strategic investments in favor of short-lived projectsthat is, toward those that
have a quick payback period.
20-9 The book (accounting) rate of return of an investment is not likely to yield a true
measure of the rate of return on the investment because it does not consider the
time value of money and because it includes in its computation accrual-based
accounting numbers (rather than after-tax cash flows). In contrast, the internal
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rate of return (IRR) of a project, because it focuses on discounted cash flows,


represents an estimate of the true (i.e., economic) rate of return on a proposed
investment. For example, a project with an estimated IRR of 14% means that the
cash flows from the project are adequate both to recover the initial investment
outlay of the project and earn a financial return of 14% on the project over the
projects useful life. Because of this, we can say that the decision rule using the
IRR is well defined; by contrast, the decision rule associated with the ARR is
defined heuristically. Further, students should understand that in practice
uniformity does not exist regarding how the ARR is calculated. Such differences
can complicate inter-divisional profitability comparisons.
20-10 The decision criterion for the NPV method is the amount and direction of the net
present value. A proposed investment with a positive NPV should be accepted.
Furthermore, a higher NPV signals a better capital investment.
The IRR method uses a different decision criterion for evaluating capital
investments. The decision criterion is the desired rate of return for the investment
project. A project is a good investment if the estimated rate of return on the
project (i.e., the IRR) exceeds the desired rate of return. The desired rate of
return can be the weighted-average cost of capital of the firm (for average-risk
projects) or a rate that the firm sets for the investment based on the unique risk
characteristics of the proposed project.
20-11 Discounted cash flow (DCF) techniques such as NPV or IRR focus on the aftertax cash flows of a proposed investment. Some maintain that such a focus might
leave out other important factors relevant to a proper analysis of a proposed
investment, such as effects of the investment on the firms strategic position,
competitive advantage, community in which the firm locates or serves, or
relationships with unions. Multi-criteria decision models, such as the AHP,
incorporate both financial and nonfinancial/qualitative criteria. The counter to this
argument is that the financial effect of such factors should be embodied in cashflow estimates used for investment analysis.
20-12 Sensitivity analysis is a tool managers can use to address uncertainty/risk
associated with the evaluation of proposed capital expenditures. Essentially, the
goal is to determine the sensitivity of the decision (e.g., whether to accept or
reject a proposed investment) to estimates of the input variables in a decision
model (e.g., project life, or discount rate in DCF decision models). Three
approaches to sensitivity analysis, in increasing complexity, are discussed in the
text: what-if analysis; scenario analysis; and, Monte Carlo simulation.
20-13 Among important behavioral factors that might affect capital investment decisions
are:
Desires of managers to grow through acquisitions and new investments
Tendency to escalate commitments
Effects of prospects on capital investment decisions
Propensity of not wanting to spend additional time and effort needed to
secure capital investments
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Intolerance of uncertainty/risk

20-14 The NPV method weighs early cash flows heavier than cash flows in the distant
future in at least two ways. First, amounts of discount applied to early cash flows
are less than those of later cash flows. Thus, one dollar to be received in the first
year increases the NPV of the investment project more than that of one dollar to
be received in, say, the fifth year of the investment. Second, each dollar earns
additional returns in each of the subsequent periods. Thus, an early dollar earns
returns over a longer period of time than that of a late dollar.
20-15 Nodepreciation expenses affect capital investment decisions in two ways:
1. They decrease periodic net incomes from investment and, thereby, provide a
reduction in income-tax payments.
2. They decrease the book value of the investment and, as a result, increase the
gain or decrease the loss from the disposal of the investment at the end of its
economic life, which in turn affects the tax liability of the firm in the year of
asset disposal.
20-16 The minimum rate of return that a firm requires may change from one year to the
next because of changes in factors associated with the estimation of the firms
weighted-average cost of capital; for example, the weights associated with its
targeted capital structure may change, the estimated risk-free rate of interest
may change, or the average interest rate on debt issued by the firm may change.
Also, as explained in the chapter, financial theory suggests that a firms
estimated weighted-average cost of capital becomes the minimum acceptable
rate of return for proposed investments of average risk. Thus, the discount rate
used to evaluate a particular investment may differ from the WACC due to the
perceived risk characteristics of that investment. The procedures for handling
such adjustments are covered in finance texts and advanced treatments of
capital budgeting.
20-17 a. The firm can expect to earn a higher return than the cost of funds needed for
the investment; thus, using the IRR decision model, this project should be
accepted. It promises to fully recover the initial investment in the project plus
provide an economic return of 11% over the life of the project.
b. A capital project that has an NPV of $148,000 based on 10 percent discount
rate (weighted-average cost of capital) indicates that the investment will earn
the firm a present-value return of $148,000 above the required 10 percent
rate of return.
20-18 A firm that chooses to build often faces many uncertainties, uses evolving
technologies, and operates in environments that are not familiar to management
and that can change rapidly. Capital budgeting processes in these firms are often
less formal, rely less on formal analyses, use more nonfinancial and nonquantifiable data (such as market share potential and competitors actions), and
apply subjective evaluation/decision criteria. These firms are likely to allow
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relatively long payback periods or low discount rates in DCF models.


In contrast, a firm that chooses to harvest is more likely to be in a mature
market. As a result, its capital budgeting processes are more likely to be
formalized. Most data needed for capital investment decisions are quantifiable
and financial in nature. For such firms, required payback periods tend to be
relatively short and discount rates (because of underlying risk) relatively high.
20-19 1. Capital budgeting is a process of assessing projects that require
commitments of large sums of funds and that generate benefits stretching
well into the future. Examples of capital budgeting projects include: purchase
of new manufacturing equipment, acquisition of new facilities, development
and introduction of new products, and expansion into new sales territories.
(Additional examples are offered at the beginning of the chapter.)
2. Differences between payback and NPV methods of capital budgeting include
recognition of time value of money, decision criterion for selecting the best
investment, number of periods considered, and the nature of the decision
rule. The payback method ignores the time value of money and, as such,
treats a dollar today the same as a dollar in the future. These two methods
also differ in terms the decision rule employed. Using the payback period
method, a superior investment is the one with a short or quick payback. The
decision criterion of the NPV method is the NPV of a proposed investment.
Under normal circumstances (see the Appendix to the chapter for the
exception to this general statement), a superior investment is the one with the
highest NPV. In addition, the payback period method considers only cash
flows needed to recover the initial investment. Cash flows after the payback
period are not included when using the payback period method. In contrast,
the NPV method includes all cash flows. Finally, the decision rule for the NPV
method is well defined conceptually: accept a project if it has a positive NPV.
In contrast, the decision rule for the payback period model is determined
subjectively/heuristically.
3. The cost of capital of a firm is the weighted average of the cost of the funds
that comprise the firms targeted capital structure. Conceptually, market rates
of return for the firms securities are used to estimate the WACC. Further, the
weights used in determining the WACC are based on market, not accounting/
book, values.
4. Financial accounting data often are not suitable for use in capital budgeting
because financial accounting uses accrual accounting in all of its
measurements. Thus, the net income of a period may include revenues not
yet paid by customers and exclude payments made to suppliers for future
deliveries. Receivables included in the revenues of the period are not
available to the firm for payments. The amount of cash paid is no longer
available for other payments, even though the payment is not an expense of
the period. In short, accrual-based accounting data, though required for
external reporting and tax purposes, do not provide relevant cash-flow data
used in DCF decision models. One way accountants can add value to the
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organization is through the estimation of all relevant cash flows associated


with a proposed investment project.

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5. As part of the overall control of capital expenditures, firms may conduct what
are referred to as post-audits (post-implementation audits). The goal is to
compare realized benefits and costs (including nonfinancial benefits and
costs) to those that were used to secure funds for the investment. In practice,
it may be difficult to untangle such items for individual projects. That is,
information gathering costs associated with individual projects can be
significant. For this reason, some companies conduct post-audits for only a
sample of investment projects.
20-20 (Appendix): With unlimited funds available at 10 percent cost, the firm needs to
ensure that all investments will earn an economic return of at least 10 percent.
As explained in the appendix, if the firm operates under a capital constraint, it
needs to compare relative returns of competing investment opportunities (e.g.,
through the use of Profitability Index information) in constructing its optimal
capital budget. The PI of a proposed investment is the ratio of the NPV of the
project to its initial outlay cost. As such, it provides a measure of the profitability
of the investment per dollar of invested capital.
20-21 (Appendix): The NPV model and the IRR model may yield conflicting results
when two investment projects are being compared and these projects differ in:
Size of initial investment
Timing of net cash inflows
Pattern of net cash inflow
Length of useful life
20-22 (Appendix): Because of the scaling process, the size of initial investment has no
effect on the rate of return as determined using the IRR model. However, a
project with a larger initial investment will likely have a higher NPV than a project
with a smaller initial investment (simply because it is bigger) and often becomes
the preferred investment when using a NPV method to analyzing capital
investments. An analogy can be drawn here to evaluating the financial
performance of organizational subunits: bigger units are advantaged when
evaluated using absolute performance measures, a situation that can be
addressed by using relative performance indicators such as ROI or IRR. Perhaps
this explains the popularity in practice of using ROI for divisional financial
performance evaluation.

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BRIEF EXERCISES
20-23 Calculating After-tax Cash Flows
Given a marginal income-tax rate of 34%:
a) The after-tax cash effect of a $1,000 increase in cash contribution margin =
increase in pre-tax cash operating income x (1 t)
= $1,000 x (1 0.34) = $660.00 increase
b) The after-tax cash effect of a $500 increase in cash operating expenses =
increase in pre-tax cash expense x (1 t)
= $500 x (1 0.34) = $330.00 decrease
20-24 Present Value of a Single Amount
Present value of $1,000 to be received two years from now (note that the
difference in answers below is attributable to the rounding):
a) Using PV table (Table 1, page 870):
1) @ 10%: $1,000 x 0.826 = $826.00
2) @ 14%: $1,000 x 0.769 = $769.00
3) @ 20%: $1,000 x 0.694 = $694.00
b) Using Excel:

20-25 Present Value of an Annuity


Given a 5-year stream of cash flows, $500 per year, at 14%:
a) Using the annuity table (see text, page 871):
PV of annuity = PV annuity factor x $500
= 3.433 x $500 = $1,716.50
b) Using the built-in PV function in Excel:

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20-26 SL Depreciation Calculation Using Excel

20-27 Calculating After-tax Cash Flows


Indirect Method:
Pre-tax Income ($260 $140 $50)
Less: Income-tax Expense
After-tax Income
Plus: Non-cash charges (depreciation)
After-tax cash flow
Direct Method:
After-tax cash operating income
($260 $140) x (1 0.35)
Plus: Depreciation tax shield
($50 x 0.35)
After-tax cash flow

=
=
=
=
=

$70.00
24.50
$45.50
50.00
$95.50

$78.00

=
=

$17.50
$95.50

20-28 MACRS Depreciation Calculations


3-year property, cost = $10,000:
Year 1 =
Year 2 =
Year 3 =
Year 4 =

$10,000 x
$10,000 x
$10,000 x
$10,000 x
Sum

33.33% =
44.45% =
14.81% =
7.41% =
= $10,000

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$3,333
$4,445
$1,481
$ 741

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20-29 Present Value of MACRS Depreciation Deductions


Net present value of depreciation tax deductions, given an after-tax discount
rate of 12.00%, MACRS 3-year property, and an asset-acquisition cost of
$10,000 = $3,218, as follows:
Asset Cost =
After-tax Discount Rate =
Marginal Income-Tax Rate =
MACRS
Depreciation
Year
%
Deduction
1
33.33%
$3,333
2
44.45%
$4,445
3
14.81%
$1,481
4
7.41%
$741
100.00%
$10,000

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$10,000
12.00%
40.00%
Tax
Savings
$1,333
$1,778
$592
$296
$4,000

20-10

PV
Factor
0.893
0.797
0.712
0.636

Present
Values
$1,191
$1,417
$422
$189
$3,218

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20-30 Sensitivity Analysis: Use of Goal Seek Function in Excel


Starting point = solution to 20-29, as follows:

Then, use the following Goal Seek commands in Excel:

Final solution: the income-tax rate must be 49.72%

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20-31 After-tax Proceeds, Asset Disposals


Given a NBV of $25,000 and a marginal income-tax rate of 34%:
a) If net sales price = $35,000 (i.e., gain situation):
After-tax proceeds = (net sales price NBV) x (1 t)
= ($35,000 $25,000) x (1 0.34)
= $10,000 x 0.66 = $6,600
b) If net sales price = $15,000 (i.e., loss situation):
After-tax proceeds = net sales price + tax savings due to loss
deduction
= $15,000 + [($25,000 $15,000) x t ]
= $15,000 + $3,400 = $18,400
20-32 Unadjusted Payback Period and NPV Using Excel
The projects NPV = $459, as follows:

Unadjusted payback period = 4.0 years


20-33 Estimating Weighted-Average Cost of Capital (WACC)
The weighted-average cost of capital (WACC) = 9.83%, as follows:

Source of Funds
Long-term Debt
Preferred Stock
Common Stock

Market Value
$40
$20
$60
$120

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(1)
Required Rate of
Return
7.00%
9.00%
12.00%

20-12

(2)
Weights
0.3333
0.1667
0.5000
1.0000

(1) x (2)
2.33%
1.50%
6.00%
9.83%

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EXERCISES

20-34 Basic Capital Budgeting Techniques (45 min)


a. Project A:

Payback Period

$5,000
$1,800

2.78 years

Or, 2 years and 10 months


b. Project B:
Year
1
2
3
4

After-tax
Cash Inflows
$ 500
1,200
2,000
2,500

Payback Period 3

Cumulative
After-tax Cash Inflows
$ 500
1,700
3,700

($5,000 $3,700)
$2,500

3.52 years

Or, 3 years and 7 months


c. Project C:
Depreciation expense per year: $5,000 5 = $1,000
Taxable income each year: $2,500 $1,000 = $1,500
Income taxes each year: $1,500 x 25% = $375
Annual after-tax net cash inflow: $2,500 $375 = $2,125

Payback Period

$5,000
$2,125

2.35 years

Or, 2 years and 5 months

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20-34 (Continued-1)
d. Project D:
(1) Depreciation expense per year: ($5,000 $500) 5 = $900
Taxable income:
Sales
Expenses:
Cash expenditures
$1,500
Depreciation
900
Operating income before taxes
Income taxes (25%)
Operating income after taxes

$4,000

2,400
$1,600
400
$1,200

Book rate of return = $1,200 $5,000 = 24.00%


(2) Average book value = ($5,000 + $500) 2 = $2,750
Book rate of return = $1,200 $2,750 = 43.64%
e. Net Present Values (@8%), rounded:
($1,800 x 3.993) $5,000 =
$7,187 $5,000 = $2,187

Project A:

Project B:
Year
0
1
2
3
4
5

After-tax
Cash Flows

8% Discount
Factor

$ 500
0.926
1,200
0.857
2,000
0.794
2,500
0.735
2,000
0.681
Net Present Value (NPV) =

Present
Values
<$5,000>
463
1,028
1,588
1,838
1,362
$1,279

($2,125 x 3.993) $5,000 =


$8,485 $5,000 = $3,485

Project C:
Project D:
Present value of cash inflows:
Years 1 through 4
Year 5
Initial investment
Net present value (NPV)

($1,200 + $900) x 3.312 =


($2,100 + $500) x 0.681 =
Present value of cash inflows =
=
=

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20-14

$6,955
1,771
$8,726
5,000
$3,726

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20-35 Weighted-Average Cost of Capital (WACC) (15 min)

a. Bond interest expense before taxes

$5,000,000 x 9% =

$450,000

$450,000 x 30% =

135,000

$315,000

$5,000,000 x 110% =

$5,500,000

$315,000 $5,500,000 =

5.73%

Income taxes on bond interest


After-tax bond interest expense
Market value of bond:
Current after-tax cost of this debt:

b. After-tax cost of preferred stock = dividend per share/market price per


c. Using weights based on the current market values of debt and equity, the
estimated WACC for this firm is 13.08%, as follows:
Interest

After-tax
or
Dividend
Book Value
Rate
Bond
$5,000,000
9%
Preferred
Stock
5,000,000
10%
Common
Stock
500,000
N/A
Total
$10,500,000

Rate or
Expected
Return
5.73%

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Current
Cost of
Market
Capital
Values
Weights Components
$ 5,500,000
0.275
1.58%

10.00%

6,000,000

0.300

3.00%

20.00%

8,500,000
$20,000,000

0.425
1.000

8.50%
13.08%

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20-36 Future and Present Values Using Excel (20 min)


A. To calculate future values, use the following Excel function:
FV(rate,nper,pmt,pv,type)
1. Between January 1, 1701 and December 31, 2007 there are 614 sixmonth periods (nper). Thus, at the end of year 2007, at an annual interest
rate of 6% compounded semiannually, the $24.00 will have grown to
$1,829,225,347, as follows:
FV(0.06/2,614,0,-24,0)
2. FV(0.08/2,614,0,-24,0) = $$689,733,898,953
3. a. FV(0.06/4,1228,0,-24,0) = $2,091,756,483
b. FV(0.08/4,1228,0,-24,0) = $873,418,055,163
4. FV(0.08/2,12,0,-9500000000,0) = $15,209,806,076
B. To calculate present values, use the following Excel function:
PV(rate,nper,pmt,fv,type)
1. For a stream of ten (10) end-of-year payments of $25,200,000 (ordinary
annuity) and a discount rate of 12%, we have:
PV(0.12,10,-25200000,0,0) = $142,385,620
2. If the first payment is received the day the contract is assigned (annuity due),
we have:
PV(0.12,10,-25200000,0,1) = $159,471,895
3. Given an income-tax rate of 45%, the after-tax cost of (1) above is:
PV(0.12,10,-25200000*0.55,0,0) = $78,312,091.17

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20-37 After-Tax Net Present Value (NPV) and IRR (40 min)
A. 1. Net cash inflow each year: $62,000 $30,000 = $32,000
Present value of net cash inflows (@10%) = $32,000 x 3.170 = $101,440
Therefore, NPV = $101,440 - $60,000 = $41,440
2. Net cash inflow before depreciation
Depreciation expense ($60,000/4 years)
Increase in net income before taxes
Income taxes rate
Income taxes

$32,000
15,000
$17,000
x
30%
$5,100

Net after-tax cash inflow = $32,000 $5,100 = $26,900 per year


Present value of net cash inflows = $26,900 x 3.170 = $85,273
Therefore, NPV = $85,273 $60,000 = $25,273
3. Double-declining balance depreciation (non-MACRS):

Year
0
1
2
3
4

Beginning
Book Value

Depreciation
Expense

$60,000
30,000
15,000
7,500

$30,000
15,000
7,500
7,500

Pre-Tax
DDB
Cash
Depreciation
Year Inflows
Expense
0
1 $32,000 $30,000
2
32,000
15,000
3
32,000
7,500
4
32,000
7,500

Taxable
Income
$ 2,000
17,000
24,500
24,500

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30%
Income
Taxes

Accumulated
Depreciation
$30,000
45,000
52,500
60,000
After-tax
Net Cash
Inflow

Ending
Book Value
$60,000
30,000
15,000
7,500
0
10%
Discount
Factor

Present
Values
<$60,000>
$ 600
$31,400
0.909
28,543
5,100
26,900
0.826
22,219
7,350
24,650
0.751
18,512
7,350
24,650
0.683
16,836
Net Present Value (NPV) = $26,110

20-17

The McGraw-Hill Companies 2008

20-37 (Continued)
b. 1.

$60,000 = $32,000 x A?, 4


A?, 4 = 1.875, which corresponds to a rate of return > 30%.
Using the IRR function of Excel, IRR = 39.08%

2.

$60,000 = $26,900 x A?, 4


A?, 4 = 2.230, which corresponds to 25% < IRR < 30%
By interpolation:
Discount Rate
25% 25%
?
30%
Difference

5%

Discount Factor
2.362
2.362
2.230
2.166

0.196

0.132

Therefore, Internal rate of return (IRR) =

25%

0.132

5% 28.37%

0.196
Or, using the IRR function in Excel, IRR = 28.27%:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-18

The McGraw-Hill Companies 2008

20-38 Basic Capital Budgeting Techniques: Uniform Net cash inflows, No Income
Taxes, Non-MACRS-Based Depreciation (45 min)

a.

Unadjusted Payback Period: As shown above, the payback period occurs


between years 4 and 5. Alternatively, the payback period = $500,000
$120,000/year = 4.17 years (about 4 years and 2 months)

b.

Book (accounting) rate of return:


As indicated above, the average increase in net income over the ten-year period
= $700,000/10 years = $70,000/year. Thus, the ARR
(1)

On initial investment:

(2)

On average investment:
Average investment:
Book rate of return:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

$70,000/$500,000 =

14.00%

($500,000 + 0)/2 =$250,000


$70,000 $250,000 =
28.00%

20-19

The McGraw-Hill Companies 2008

20-38 (Continued)

c.

NPV: using the PV factors from Table 2 (p. 871), NPV = $178,120
Based on the NPV function of Excel, the NPV = $178,027 (the difference in
NPV estimates is due to rounding that takes place when using the PV factors
provided in the Table 2 rather than the built-in NPV function)

d.

Present value payback period: as indicated in the above schedule, the present
value payback period is 6-plus years; this is the time it takes for the present
value of future cash inflows to cover the original investment outlay of $500,000

$6,560

6 years +

= 6.12 years (6 years, 2 months)

$54,240
e.

Internal rate of return: as indicated in the above schedule, we can use the builtin function in Excel to estimate the IRR for this proposed investment; IRR =
20.18%
Alternatively, we can estimate the IRR as follows. We are looking for an
interest/discount rate that provides for a NPV = $0 (i.e., a rate that provides a
present value of future cash inflows equal in amount to the original investment
outlay, $500,000). Thus,
PV of net cash inflows:
At 20% (i.e., a rate too low): $120,000 x 4.192
At 25% (i.e., a rate too high): $120,000 x 3.571
Difference in PV with 5% difference in discount rate

IRR = 20% +

$503,040 - $500,000

=
=
=

$503,040
428,520
$ 74,520

5% = 20.20%

$74,520

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-20

The McGraw-Hill Companies 2008

20-39 Basic Capital Budgeting Techniques: Uneven Net Cash Inflows, Income Taxes, Non-MACRS Depreciation
Calculations (50 min)

a.

Unadjusted Payback Period: as shown by the above schedule, the payback period is between 4 and 5 years.
Using a linear interpolation, we estimate the payback period as

Payback Period = 4 years +

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-21

$125,000
= 4.68 year s
$183,000

The McGraw-Hill Companies 2008

20-39 (Continued)
b.

Book (accounting) rate of return:


As indicated above, the average increase in after-tax operating income over the ten-year period = $812,000/10
years = $81,200/year. Thus, the ARR
(1)

On initial investment:

$81,200/$500,000 = 16.24%

(2) Average investment = ($500,000 + 0)/2 =


$250,000
Book rate of return on Average Investment = $81,200 $250,000 = 32.48%
c.

NPV: using the PV factors from Table 2 (p. 871), NPV = $203,866
Based on the NPV function of Excel, the NPV = $203,781 (the difference in NPV estimates is due to rounding that
takes place when using the PV factors provided in the Table 2 rather than the built-in NPV function).

d.

Present value payback period: as indicated in the above schedule, the present value payback period is 4-plus
years; this is the time it takes for the present value of future cash inflows to cover the original investment outlay of
$500,000.

e.

Internal rate of return (IRR): as indicated in the above schedule, we can use the built-in function in Excel to
estimate the IRR for this proposed investment; thus, IRR = 19.88%
Alternatively, we can estimate the IRR as follows. We are looking for a interest/discount rate that produces a NPV
= $0 (i.e., a present value of cash inflows equal in amount to the original investment outlay, $500,000). Thus,
PV of net cash inflows at 18% (i.e., an interest rate too low):
PV of net cash inflows at 20% (i.e., an interest rate too high):
Difference in PV with 2% difference in discount rate

$540,042
$497,623
$ 42,419

Therefore,
Internal rate of return (IRR)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

18% +

20-22

$540,042 - $500,000
2% = 19.89%
$42,419

The McGraw-Hill Companies 2008

20-40 Basic Capital Budgeting Techniques: Uneven Net Cash Inflows, Income Taxes, and MACRS Depreciation
(60 min)

1. Payback period: as shown by the above schedule, the payback period is between 4 and 5 years. Using a linear
interpolation, we estimate the payback period as

Payback Period = 4 years +

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

$60,920
$185,280

20-26

= 4.33 years

The McGraw-Hill Companies 2008

20-40 (Continued)
2. Book rate of return (ARR):
Average after-tax operating income/year:

$812,000/10 =

$81,200

Book (accounting) rate of return (ARR):


a. On initial investment:

$81,200/$500,000 = 16.24%

b. On average investment:
Computation of Simple Average Annual Investment:
Book Value,
Beginning-ofYear
Year
Average
investment:
1
$500,000
2
400,000
3
240,000
4
144,000
5
86,400
6
28,800
7
8
9
10
Totals

Depreciation
Average BV
Expense for
Book Value,
During the
the Year
End-of-Year
Year
$1,149,200/10
=
$114,920
$100,000
$400,000
$450,000
160,000
240,000
320,000
96,000
144,000
192,000
57,600
86,400
115,200
57,600
28,800
57,600
28,800
0
14,400
0
0
0
0
0
0
0
0
0
0
0
0
$500,000
$1,149,200

Book rate of return (ARR): $81,200/$114,920 = 70.66%


3.

Net Present Value (NPV): as indicated in the above schedule, the NPV of the
proposed investment is $229,821 (based on PV factors from Table 1, p. 870). Based
on the built-in NPV function in Excel, the estimated NPV is $229,743. The difference
in estimates is due to the rounding that is embodied in the PV factors taken from
Table 1.

4. Internal Rate of Return (IRR): as indicated in the above schedule, we can use the
built-in function in Excel to estimate the IRR for this proposed investment; IRR =
21.46%. Alternatively, we can use a linear interpolation procedure to estimate the
projects IRR, as follows: we are looking for an interest/discount rate that produces a
PV of cash inflows equal to the net original investment outlay ($500,000). Thus,
PV of net cash inflows at 20% (a rate that is too low):
PV of net cash inflows at 22% (a rate that is too high):
Difference in PV with 2% difference in discount rate:
Thus,

IRR = 20% +

$27,875

$527,875
$490,273
$ 37,602

2% = 21.48%

$37,602

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-27

The McGraw-Hill Companies 2008

20-41 Straightforward Capital Budgeting with Income Taxes (Non-MACRS-based


Depreciation) and Sensitivity Analysis (20 min)
1.

Depreciation per year, SL basis: ($30,600 $600)/6 years = $5,000


Taxable income

$8,000 $5,000 =

Tax rate

3,000
x

Income taxes

40%
$1,200

Pre-tax annual cash flow (cash savings) = $8,000


Net after-tax annual cash inflow: $8,000 $1,200 = $6,800
2.

Payback period: $30,600/$5,000 = 6.12 years (if cash flows are assumed to occur at
end of year, then the appropriate answer would be 7 years)

3.

PV of annual after-tax cash savings

$5,000 x 4.623 =

PV of salvage value

$ 600 x 0.63 =

Total Present Value of Cash Inflows

378
$23,493

Initial Investment Cash Outlay

30,600

NPV

4.

$23,115

($7,107)

The minimum net after-tax annual cost savings needed to justify this investment =
$6,537
Let X = minimum after-tax annual cost savings, and let NPV =0. The Initial
Investment Outlay ($30,600) is reduced by the PV of the salvage value of the asset
@ an 8% discount rate (i.e., $378). Thus, when NPV = $0, we have (by definition):
PV of After-tax Cash Inflows = PV of Cash Outflows
4.623 X = $30,600 $378
X = $30,222/4.623 = $6,537
(or, an increase of approximately 31% over the $5,000 amount given assumed
above in 2 and 3)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-28

The McGraw-Hill Companies 2008

20-42

Capital Budgeting with Tax, Non-MACRS Depreciation, and Sensitivity


Analysis (35 min)
Annual after-tax net cash inflow:
$1,200 x (1 0.35) =
($6,000/10) x 0.35 =

Cash revenue
Tax saving on depreciation expense
Total
1. Payback period:

$6,000
$990

$780
210
$990

= 6.06 years

2. Estimated Operating Income per year:


Sales
Depreciation
Operating income before taxes
Taxes
Operating income

$1,200
600
$ 600
210
$ 390

Therefore,

Book rate of return =

3.

$390
$6,000

= 6.5%

The maximum initial investment is such that the project at this level of investment
would yield a NPV = $0 (i.e., a situation where PV of cash inflows = PV of cash
outflows). The appropriate annuity factor for 10 years, 15% is 5.019. Let X =
maximum initial investment, then:
X = $990 x 5.019 = $4,969

4.

Required annual (pre-tax) cash revenue:


Given an initial investment outlay of $6,000, the after-tax
annual cash flow needed per year to generate a return
of 15% = $6,000/5.019 =
$1,195
Less: Annual Tax savings on depreciation expense =
210
Required after-tax annual cash revenue
$985
(1 t)
0.65
Annual (pre-tax) cash revenue needed
$1,515

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-29

The McGraw-Hill Companies 2008

20-42 (Continued)

5.

NPV Calculations under different assumptions regarding the discount rate


(required rate of return) and annual after-tax net cash inflows. Assume a ten-year
life and an initial investment outlay of $6,000.
Discount
Rate
10%
15%
20%

PV Annuity
Factor
6.145
5.019
4.192

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

Annual Net After-Tax Cash Flow


$500
$1,000
$2,000
($2,928)
$145
$6,290
($3,491)
($981)
$4,038
($3,904)
($1,808)
$2,384

20-30

The McGraw-Hill Companies 2008

20-43 Basic Capital Budgeting (10-15 mins)


1. The after-tax cash flow from disposal of the old machinery =
after-tax gain on sale = ($1,800 $0) x (1 t) = $1,800 x 0.60 =

$1,080

2. The PV of after-tax operating cash savings = pre-tax operating cash savings x (1


t) x PV annuity factor = $12,500 x 0.60 x 3.17 = $23,775
3. The PV of the depreciation tax-shield, year 1 = depreciation deduction x incometax rate x PV factor = $10,000 x 0.40 x 0.909 = $3,636
4. C

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-31

The McGraw-Hill Companies 2008

20-44

PROBLEMS
Equipment Replacement Decision; Strategy (60 min)

1. & 3.

Overhaul AccuDril
Operating Cost1
Overhaul cost
Tax savings on deprec.2
Other Expenses3
Net after-tax cash flows:
Year 1
Year 2
Year 3
Year 4
Year 5
Total PV
Buy RoboDril 1010K
Net Equip. Purchase4
Operating Cost5
Tax savings on depr.6
Other expenses7
Salvage value8
Total PV

PV/
Annuity
Factor

Present
Value

After-tax Cash Flows (000s)


1
2
3
(48.0)
4.0
(57.0)

0.893
0.797
0.712
0.636
0.567

($90,193)
(160,197)
( 56,533)
( 50,498)
( 45,020)
($402,441)

1.000
3.605
3.605
3.605
0.567

($240,000)
(86,520)
69,216
(118,965)
17,010
($359,259)

(48.0)
(100.0)
4.0
(57.0)

(38.4)

(38.4)

(38.4)

16.0
(57.0)

16.0
(57.0)

16.0
(57.0)

(101.0)
(201.0)
(79.4)
(79.4)
(79.4)

(240.0)
(24.0)
19.2
(33.0)

(24.0)
19.2
(33.0)

(24.0)
19.2
(33.0)

(24.0)
19.2
(33.0)

PV difference in cash flow between alternatives= $402,441 $359,259 = $43,182 in favor of RoboDril

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-33

The McGraw-Hill Companies 2008

(24.0)
19.2
(33.0)
30.0

20-44 (Continued-1)
NOTES
1

Years 1 and 2: $10 per hour x 8,000 hours x (1 t) =


Years 3, 4, and 5: $48,000 x (1 20%) =

$48,000
$38,400

Years 1 and 2:
Depreciation expense per year (SL basis):
($120,000 $20,000) 10 =
Income Tax Rate (t)
Tax savings on depreciation, Years 1 and 2

$10,000
x
0.40
$ 4,000

Years 3, 4, and 5:
Book value before overhaul (end of original useful life)
Overhaul cost, Year 3
Total amount to be depreciated
Number of years
Depreciation expense per year
Income Tax Rate (t)
Tax savings on depreciation, Years 3, 4, and 5

$ 20,000
100,000
$120,000

3
$ 40,000
x
40%
$ 16,000

$95,000 x (1 t) = $95,000 x 0.60 = $57,000

Purchase price
Installation, testing, rearrangement, and training
Subtotal
$280,000
Trade-in allowance for AccuDril
Net purchase cost

$250,000
+
30,000

($10/hour x 4,000 hours) x (1 t) = $40,000 x 0.60 =

$24,000

Depreciation expense per year: $240,000 5 Years =


Income Tax Rate (t)
Annual Tax savings on depreciation deduction

40,000
$240,000

$48,000
0.40
$19,200

$55,000 x (1 t) = $55,000 x 0.60 =

$33,000

($50,000 - $0) x (1 t) = $50,000 x 0.60 =

$30,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-34

The McGraw-Hill Companies 2008

20-44 (Continued-2)

2.
Year
0

Net After-tax Cash Flows


AccuDril
RoboDril
$0
($240,000)

Difference in
Cash Flows
($240,000)

Cumulative
Difference
($240,000)

($101,000)

($37,800)

$63,200

($176,800)

($201,000)

($37,800)

$163,200

($13,600)

($79,400)

($37,800)

$41,600

Thus, the payback period for investing in the new machine is 2-plus years. Using a
linear interpolation method, we estimate the payback period as:
Payback period = 2 years +

$13,600

= 2.33 years

$41,600

4. Among other factors that the firm should consider before the final decision are:
Changes in technology for equipment
Changes in market, especially demand for the product and competitors
Reliability of the new machine and the expected effects of overhaul
Reliability of AccuDril and accuracy of the estimates given
Competitive strategy of the firm
Differences in product qualities manufactured by the two machines

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-35

The McGraw-Hill Companies 2008

20-45 Sensitivity Analysis (75 min)


1. Difference in PV between the two alternatives = $402,441 $359,259 = $43,182.
We focus on the reduction in variable operating cost needed each year (3 through 5)
after the old machine is overhauled.
The equivalent annuity factor needed to convert this stream of after-tax cash flows
(cost savings) to a present value is found in either of two ways:
(1) Annuity factor (@12%) for three years = 2.402; this annuity factor needs to be
brought back two years, to get a present value of the cash flows in years 3
through 5: 2.402 x 0.797 = 1.914
(2) Alternatively, we could sum the PV factors from years 3, 4, and 5:
0.712 + 0.636 + 0.567 = 1.914
Thus, the additional annual after-tax operating cost savings needed from
improvement to make the overhaul of AccuDril a financially attractive choice =
$22,561, as follows:
$43,182

= $22,561

1.914

On a before-tax basis (given an income tax rate of 40%), the required operating cost
savings in each of years 3, 4, and 5 would be:
$22,561

= $37,602

0.6

$37,602
$80,000

= 47%

In sum, for the replacement decision to be in error financially, the after-tax variable
operating costs would have to be reduced, in years 3-5, by 47%.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-36

The McGraw-Hill Companies 2008

20-45 (Continued-1)
2. The beginning spreadsheet contains the PV of each alternative:

Then, use the following Goal Seek commands in Excel:

This produces the following result (cell E11): the maximum amount that the annual
after-tax operating costs for the new machine can be = $36,000 (a 50% increase
from the current $24,000):

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-37

The McGraw-Hill Companies 2008

20-45 (Continued-2)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-38

The McGraw-Hill Companies 2008

20-45 (Continued-3)

3.

Discount
Factor

Present
Value

Cash Flows (in 000s of dollars)


1
2
3
4

Overhaul in 2 years:
Tax savings from depreciation1
Overhaul cost

4.0
0.893
0.797
0.712
0.636
0.567

$3,572
$(76,512)
$11,392
$10,176
$ 9,072
$(42,300)

PV of overhaul in 2 years

16.0
16.0

4.0

4.0

4.0

33.6

Thus, by a small amount, it is better (financially) to overhaul now and again in 2 years.

20-39

2
(30.0)
9.6
24.0

(80.0)

Difference in cost between the two alternatives: $42,300 - $39,466 = $2,834

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

16.0

16.0

9.6
24.0
$(80,000)
$30,005
$2,869
$2,848
$2,544
$2,268
$(39,466)

16.0

(96.0)

(80.0)

1.000
0.893
0.797
0.712
0.636
0.567
PV of Overhaul now and again in 2 years

16.0

4.0

Overhaul now and again in 2 years:


Overhaul cost
Savings from Improved efficiency2
Tax savings on depreciation3

4.0
(100.0)

The McGraw-Hill Companies 2008

3.6
4.0
4.0
4.0

20-45 (Continued-4)
1

See part (1), Problem 20-44, reproduced as follows:


Years 1 and 2:
Depreciation expense per year (SL basis):
($120,000 $20,000) 10 years =
Income Tax Rate (t)
Tax savings on depreciation, Years 1 and 2

$10,000
x
0.40
$ 4,000

Years 3, 4, and 5:
Book value before overhaul (end of original useful life)
Overhaul cost, Year 3
Total amount to be depreciated
Number of years
Depreciation expense per year
Income Tax Rate (t)
Tax savings on depreciation, Years 3, 4, and 5

$ 20,000
100,000
$120,000

3
$ 40,000
x
40%
$ 16,000

Savings from the improved productivity = $10/hr. x 8,000 hours x 20% = $16,000
Less: Income Taxes on the savings (@40.0%) =
6,400
After-tax savings
$9,600

Years 1 and 2:
Book value at the time of overhaul: $10,000 x 2 + $20,000 =
Overhaul cost
Total amount to be depreciated
Number of years
Depreciation expense per year
Tax Rate
Tax savings on depreciation

$ 40,000
+ 80,000
$120,000

2
$60,000
x
0.40
$24,000

Years 3, 4, and 5:
Overhaul cost
Number of years
Depreciation expense per year
Income tax Rate
Tax savings on depreciation

$30,000

3
$10,000
x
0.40
$ 4,000

4. As a follow-up to (3) above: although the cost difference between the two
alternatives is only $2,834, which is less than 0.3% of the annual sales dollars
($1,000,000), the benefit from offering higher quality products two years earlier
will most likely persuade the firm to undertake the overhaul two years early.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-40

The McGraw-Hill Companies 2008

20-46

Comparison of Capital Budgeting Techniques; Sensitivity Analysis


min)

(50

1. Effects of the new equipment on operating income after tax:


Sales
$195 x 10,000 =
Cost of goods sold:
Variable manufacturing costs
$ 90
Fixed manufacturing costs:
Additional fixed manufacturing overhead:
$250,000/10,000 units =
$25
Depreciation on new equipment:
($995,000 $195,000)/4 = $200,000/year
$200,000/10,000 units per year = + 20 + 45
Manufacturing cost per unit
$135
Times: Number of units
x 10,000
Total cost of goods sold
Gross margin
Operating Expenses:
Variable marketing: Cost per unit
$ 10
Number of units
x 10,000 $100,000
Additional fixed marketing cost
+ 200,000
Operating income before taxes
Income taxes (@30%)
Operating income after tax

$1,950,000

1,350,000
$ 600,000

300,000
$300,000

90,000
$210,000

Thus, the company will increase its after-tax operating income by $210,000 each
year.
2.
After-tax operating income
Add: increased depreciation expense
After-tax cash inflow from disposal of equipment
Total cash inflow

Years
1 to 3
$210,000
200,000
$410,000

Year 4
$210,000
200,000
195,000
$605,000

The new machine will increase cash inflows by $410,000 in each of the first three
years and $605,000 in Year 4.
3.

Payback Period =

$995,000

= 2.43 years

$410,000
4.

Average investment = ($995,000 + $195,000)/2 = $595,000


Average after-tax operating income = $210,000
Book rate of return (ARR) based on average investment =

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-41

The McGraw-Hill Companies 2008

$210,000/$595,000

= 35.29%

20-46 (Continued-1)
5.

Using PV and Annuity Tables:


PV of after-tax cash inflows (@14%):
Years 1 through 3:
$410,000 x 2.322 =
$
Year 4 ($410,000 + $195,000):
$605,000 x 0.592 =
Total present value future after-tax cash inflows
=$1,310,180
Less: Initial investment outlay
NPV of the proposed investment
$

952,020
358,160
995,000
315,180

Using the NPV Function in Excel:

Thus, the estimated NPV of the investment = $315,078 (note the rounding error
that occurs when using the PV and annuity factors)
6.

Trial-and-Error Approach (initial investment outlay = $995,000):


PV of cash flows @ 25%:
($410,000 x 1.952) + ($605,000 x 0.410)
PV of cash flows @ 30%:
($410,000 x 1.816) + ($605,000 x 0.350)
Difference in PV of after-tax cash inflows

$1,048,370
$ 956,310
$ 92,060

Thus, the estimated IRR for this investment is:

IRR = 25% +

$1,048,370 - $995,000

5% = 27.90%

$92,060

Based on the built-in function in Excel, the estimated IRR of this project = 27.80%,
as follows:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-42

The McGraw-Hill Companies 2008

20-46 (Continued-2)

7. a. Based on an estimated NPV of $315,078 (part 5, above), the PV of any after-tax


increase in variable costs associated with units produced by the new machine =
$315,078. Thus, the annual after-tax increase that would be permissible =
$315,078/2.914 = $108,126.
To convert this annual cost to a pre-tax basis, we would have to divide by the
quantity (1 t), where t = the income-tax rate (30.0%). Thus, the maximum
increase in pre-tax variable cost = $108,126/0.70 = $154,466.
Therefore, the variable cost per unit can increase by a maximum of
$154,466/10,000 units = $15.45 per unit. At this increase, the new equipment
would generate a rate of return of exactly 14%its cost of capital.
b. The maximum pre-tax decrease in selling price = $154,466 (see (a) above). On a
per-unit basis, for all units sold, the maximum decrease in unit selling price is
therefore equal to $7.72 (rounded), that is, $154,466/20,000 units. This would
represent a decrease of approximately 4% ($7.72/$195.00).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-43

The McGraw-Hill Companies 2008

20-47

1.

Replacing a Small Machine: Capital Budgeting Techniques and


Sensitivity Analysis (50 min)

Although the new machine has the capacity of turning out 18,000 units per year, the
analysis should be based on 10,000 units per year because there is currently no
demand for the last 8,000 units. This is a mistake that students often make.
Year 0
Purchase price of the new machine
Proceeds from disposal of old machine
Income taxes on gain on disposal (@20%)
Net cash flow, year of purchase

($100,000)
$3,000
(600)

Years 1-4
After-tax cash operating costs, current machine:
($40,000 + 10,000 + 10,000) x (1 0.20)
=
After-tax cash operating costs, new machine:
($30,000 + 2,000 + 1,000) x (1 0.20)
=
After-tax savings in cash operating costs with the new machine
Incremental tax savingsdepreciation expense:
Deprec. expense, new machine: $100,000 5 =
$20,000
Income tax rate = x
20%
Annual income-tax savings, new machine
=
$4,000
Less: Tax savings due to depreciation on
old machine
=
$0
Incremental after-tax cash inflows per year
Year 5
Incremental after-tax cash inflows, operating cost savings
Incremental after-tax disposal value of new machine:
After-tax cash inflow, disposal of new machine:
$5,000 x (1 0.20) =
$4,000
After-tax cash inflow, disposal of old machine:
$1,000 x (1 0.20) =
$800
Total cash inflow in year 5

2,400
($97,600)

$48,000
26,400
$21,600

$4,000
$25,600

$25,600

$3,200
$28,800

2.

PV of incremental after-tax cash inflows, years 14: $25,600 x 3.170 = $ 81,152


PV of incremental after-tax cash inflow, year 5: $28,800 x 0.621
=
17,885
Total PV of incremental after-tax cash inflows
$99,037
Less: Net initial after-tax cash outlay
97,600
NPV of proposed investment (@ 10%)
$ 1,437

3.

Payback period = $97,600 $25,600 = 3.81 years

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-44

The McGraw-Hill Companies 2008

20-47 (Continued-1)
4.

The annuity factor needed is approximately 3.904 ($97,600 $25,000)


Interest Rate
8%
8%
?
9%
1%
?

Discount Factor
3.993
3.993
3.904
3.890
0.103
0.089

Thus, the estimated IRR of the proposed investment is 8.86%, as follows:

IRR = 8% +

0.089

1% = 8.86%

0.103
5. Trial-and-Error Approach (Using Table 1, p. 870)--we are looking for a discount
rate that, when applied to the given cash flows, produces a $0 NPV (given the initial
investment outlay of $97,600):

Year

Cash
Inflows

Discount
factor at 10%

PV at
10%

Discount
factor at 12%

PV at
12%

1
2
3
4
5

$20,000
22,000
25,000
30,000
40,000

0.909
0.826
0.751
0.683
0.621

$ 18,180
18,172
18,775
20,490
24,840
$100,457

0.893
0.797
0.712
0.636
0.567

$17,860
17,534
17,800
19,080
22,680
$94,954

Interest Rate
10%
10%
?
12%
2%
?

PV of net cash inflows


$100,457
$100,457
97,600
94,954
$5,503
$2,857

Thus, the estimated IRR of the project equals approximately 11%, as follows:

IRR = 10% +

$2,857
$5,503

2% = 11.04%

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-45

The McGraw-Hill Companies 2008

20-47 (Continued-2)
Using Built-in Function in Excel: the projected IRR for this investment is 11.02%, as
follows:

6. PV of allowable after-tax increase in variable cost = NPV of the investment annuity


factor (10%, 5 years) = $1,437 3.791 =
$379
1 income-tax rate

0.8
Allowable pre-tax increase in variable costs per year
$474
Number of units
10,000
Allowable cost increase per unit
$0.0474
Thus, the indifference point = $3.3474 ($3.30 + 0.0474) per unit. As such, the
purchase of SP1000 will be the correct decision as long as management is confident
that the estimated new variable cost will be within 1.4 percent of the estimated
amount ($0.0474/$3.30). This is not likely a large margin of error. Thus, the decision
may ultimately rest on qualitative/ strategic factors.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-46

The McGraw-Hill Companies 2008

20-48

Capital
Budgeting
with
Sum-of-the-Years-Digits
Spreadsheet Application (25 min)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-47

Depreciation;

The McGraw-Hill Companies 2008

20-49

Working Backward: Determine Initial Investment Based on Book Rate of


Return (15 min)

Let Y = Cost of the new machine (i.e., required initial investment)


Then,

($6,750

) (1 0.20)
10
0.10
Y

($6,750 0.10Y) x 0.8 = 0.10Y


Initial investment = $30,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-48

The McGraw-Hill Companies 2008

20-50 Determine Initial Investment Based on Internal Rate of Return (10 min)
Let C be the cost of the machine. Then,
after-tax cash flow per year x annuity factor for 6 years, 10% = C
[$20,000 (($20,000 C/6) x 0.20)] x 4.355 = C
[$20,000 $4,000 + 0.03333C] x 4.355 = C
$69,680 + 0.14517C = C
C = $69,680/0.8548 = $81,516

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-49

The McGraw-Hill Companies 2008

20-51 Determine Periodic Cash Flow Based on Book (Accounting) Rate of Return
(ARR) (15 min)
Let Y be the firm's after-tax operating income. Then,

= 0.15

$60,000
Y = $9,000 per year
Pre-tax operating income = After-tax operating income/(1 - t)
= $9,000/(1 - 0.25) = $12,000 per year
Now, let X = pre-tax cash flow from operations. Then,
Operating income before taxes = X
$12,000 = X

Non-cash charges
($60,000/5)

So that,
X = $12,000 + $12,000 = $24,000

Check:
Pre-tax Operating Income
Less: Income Taxes ($12,000 x 0.25)
After-tax Operating Income
Plus: Depreciation Expense
After-tax cash flow
Plus: Income taxes
Pre-tax operating cash flow

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-50

$12,000
($3,000)
$9,000
+ $12,000
$21,000
+ $3,000
$24,000

The McGraw-Hill Companies 2008

20-52

Machine Replacement and Sensitivity Analysis without Taxes


(40 - 50 min)
Net additional cash outlay for the new machine (@ March 5, 2008):
$8,000 $3,000 = $5,000

1. a.

Payback period: $5,000/$750 = 6.67 years

b.
Depreciation:

Old
($5,000 $600)/11

New
($8,000 $400)/10

= $400

Difference

= $760

$360

Operating expense (cash)

($750)

Difference in annual pre-tax income (reduction in expenses)

$390

Loss on trade-in of existing asset (at March 5, 2008) =


book value of asset trade-in value = ($5,000 $400) $3,000
= $1,600 (this loss complicates the determination of ARR, but not
NPV or IRR for the proposed investment)
Book values:
3/5/2008

($5,000 $400 deprec.)

3/5/2018
Average Investment (Book Value)

Old
$4,600

New
$8,000

600

400

$2,600

$4,200

Therefore, the incremental average investment on the new machine


= $4,200 - $2,600 = $1,600
The average incremental income, including recognition of the loss on disposal of the
existing machine, is $130, as follows:
Ten-Year Difference in Pre-tax Income = 10 x $390 =
Less: Loss on disposal of existing asset = $4,600 - $3,000 =
Total income difference in favor of new machine =
Average annual income difference =

$3,900
($1,600)
$2,300
$230

Thus, under the specified treatment of the loss on disposal of the existing machine, the
ARR of the proposed replacement decision is slightly over 14%, as follows:

ARR =

$230

= 14.38%

$1,600

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-51

The McGraw-Hill Companies 2008

20-52 (Continued)
Students should be alerted to other possible treatments for the loss and to the
fact that this is a good example of one of the ambiguities associated with the
use of the ARR for capital investment decision-making.
c. NPV = ($750 x 5.650) ($8,000 $3,000) [($600 - $400) x 0.322]
= $4,237.50 $5,000.00 $64.40 = ($826.90)
d. Given a negative NPV, we know that the IRR must be less than the discount
rate (12%). We are looking for a discount rate that produces a PV of future
cash inflows = $5,000 (net investment outlay for the new machine). We try,
somewhat arbitrarily, 7% and 8%, as follows:
PV of net cash inflows at 7% = ($750 x 7.024) ($200 x 0.508)

$5,166

PV of net cash inflows at 8% = ($750 x 6.710) ($200 x 0.463)

4,940

Difference

$ 226

the estimated IRR = 7.73%, as follows:

7% +

166
226

1% = 7.73%

2.

No, because NPV < $0 (NPV is $826.90). Note that the decision based on the
ARR is ambiguous.

3.

Because the expected NPV of the project is negative, the firm would have to
realize operating cost savings greater than those originally assumed. Let the
required pre-tax annual savings = Y. Then, to make NPV = $0, we must have:
PV of Cash Savings

Original Investment Outlay

5.650Y - ($200 x 0.322)

$5,000

5.650Y =

$5,064.40

Y=

$896.35

(That is, the maximum savings per year before the decision not to invest is
changed. This revised amount represents a change of approximately 19.5% above
the current estimate of $750. Note that at annual cash savings of $896.35, the IRR
on the proposed investment would exactly equal 12%, the companys cost of
capital.)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-52

The McGraw-Hill Companies 2008

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-53

The McGraw-Hill Companies 2008

20-53 Value of Accelerated Depreciation (25 min)


1.

The incremental PV of using SYD depreciation rather than SL depreciation, at a


discount rate of 8%, is $1,272, as follows:

Year
1

2.

Depreciation Method
SYD
S-L
$40,000
$25,000

Difference
Amount
Tax Effect
$15,000
$6,000

PV
Factor
at 8%
0.926

PV of
Tax Effect
$ 5,556

30,000

25,000

5,000

2,000

0.857

1,714

20,000

25,000

(5,000)

(2,000)

0.794

(1,588)

10,000

25,000

(15,000)

(6,000)

0.735

(4,410)

$100,000

$100,000

$1,272

The incremental PV of using DDB depreciation rather than SL depreciation, at a


discount rate of 8%, is $1,615, as follows:

Year
1

Depreciation Method
DDB
S-L
$50,000
$25,000

Difference
Amount Tax Effect
$25,000
$10,000

PV
Factor
at 8%
0.926

PV of
Tax Effect
$9,260

25,000

25,000

-0-

-0-

0.857

12,500

25,000

(12,500)

(5,000)

0.794

(3,970)

12,500

25,000

(12,500)

(5,000)

0.735

(3,675)

$100,000

$100,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

-0-

$1,615

20-54

The McGraw-Hill Companies 2008

20-53
3.

(Continued)

The incremental PV of using MACRS depreciation, rather than SL depreciation, at


a discount rate of 8%, is $1,345, as follows:

Year
1

Depreciation Method
MACRS
S-L
1
$33,330
$25,000

Difference
Amount Tax Effect
$8,330
$3,332

PV
Factor
PV of
at 8% Tax Effect
0.926
$3,085

44,4502

25,000

19,450

7,780

0.857

6,667

14,8103

25,000

(10,190)

(4,076)

0.794

(3,236)

7,4104

25,000

(17,590)

(7,036)

0.735

(5,171)

$100,000

$100,000

$1,345

Notes:
1
$100,000 x 33.33%
2
$100,000 x 44.45%
3
$100,000 x 14.81%
4
$100,000 x 7.41%

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-55

The McGraw-Hill Companies 2008

20-54 Capital Budgeting with Sensitivity Analysis (45 min)


1.

Expected annual net cash inflows ($600,000 + $100,000)


Income taxes at 30%
After-tax net cash inflows

=
=
=

$700,000
210,000
$490,000

The buyer is essentially purchasing an eight-year stream of after-tax rental incomes


and income-tax savings associated with the depreciation deduction. Thus, a rational
purchase price would be the PV of these future cash flows, using 12% as the
discount rate. Note, however, that the depreciation deduction is a function of the
purchase price, which we are trying to estimate. Therefore, let P denote the
maximum price the buyer would be willing to pay. The amount is approximately $3
million, as follows:
P = [$490,000 x A.12, 8] + [(P/8 x 0.3) x A.12, 8]
P = [$490,000 x 4.968] + [P/8 x 0.3 x 4.968]
P = $2,434,320 + 0.1863P
0.8137P = $2,434,320
P = $2,991,668
2.

From Meidis perspective, the selling price should be set such that it would cover
three things: (1) the PV of the after-tax rental incomes she is foregoing, (2) capital
gains taxes she would have to pay on the sale of the real estate, and (3) the sales
commission (5%) she has to pay the real estate broker. Thus, if this is the case,
Let S denote the minimum price Meidi would be willing to accept
S
S
S
0.57S
S

3.

=
=
=
=
=

[$460,000 x A.10, 8] + [(S $800,000 0.05S) x 0.40] + 0.05S


[$460,000 x 5.335] + [0.38S $320,000] + 0.05S
$2,454,100 + 0.43S $320,000
$2,134,100
$3,744,035

MACRS depreciation increases to the buyer the PV of the depreciation write-offs


(compared to the use of the SL method, as in (1) above). Thus, to the extent the
buyer could realize these tax savings, the buyer would be willing to pay a higher
price for the property.
As in (1) above, we represent the maximum price the buyer would be willing to pay
as the sum of two components: the PV of after-tax rental incomes ($2,434,320)
plus the PV of the tax savings due to the depreciation deductions over the life of
the property. This second component is represented as 0.2214397P (where P
represents the purchase price, and therefore depreciable cost, of the property), as
follows:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-56

The McGraw-Hill Companies 2008

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-57

The McGraw-Hill Companies 2008

20-54 (Continued)

Year
1
2
3
43
5
6

(1)
MACRS
Depreciation1
0.2000P
0.3200P
0.1920P
0.1152P
0.1152P
0.0576P

(2)
Tax Effect2
0.06000P
0.09600P
0.05760P
0.03456P
0.03456P
0.01728P

(3)
PV Factor
0.893
0.797
0.712
0.636
0.567
0.507

(2) x (3)
Present Value
0.0535800P
0.0765120P
0.0410112P
0.0219801P
0.0195955P
0.0087609P
0.2214397P

Notes:
1
See text, Exhibit 20.6 for MACRS depreciation rates, 5-year property
2
Assuming a 30% marginal income-tax rate.
3
First year of switching to SL depreciation method.
Thus, the maximum amount that a rational buyer would be willing to pay has
increased to $3,126,694, as follows:
P = $2,434,320 + 0.2214397P
0.7785603P = $2,434,320
P = $3,126,694 (an increase of $135,026 over the amount
calculated above in (1))

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-58

The McGraw-Hill Companies 2008

20-55
1.

Cash Flow Analysis and NPV (40 min)

Item & Description


a. After-tax rent foregone
($5,000 x 0.6)
b. All are irrelevant
c. Remodeling cost
Deprec. tax savings2

d. Investment in net
working capital
Recovery
e. Irrelevant
f. Sales ($900 x 0.6)
Operating expenses
($500 x 0.6)
g. Sales Promotion ($100 x 0.6)
h. Termination ($50 x 0.6)
NPV

PV
Factor

PV

N/A

($128,931)1
(100)

0.877
0.769
0.675
0.592
0.519

($100,000)
$14,032
$7,382
$ 3,888
$2,557
$2,242
($600,000)
$311,400

(600)

0.519
3.433

(36)

(36)

(36)

(36)

(36)

16
9.6
5.76
4.32
4.32

600

$1,853,820

3.433 ($1,029,900)
($60,000)
0.519
($15,570)
$260,920

CASH FLOWS IN YEAR (in '000)


1
2
3
4

540

540

540

540

540

(300)

(300)

(300)

(300)

(300)

(60)
(30)

Notes:
1
Use the PV function in Excel to determine the PV of a stream of 60 monthly cash receipts ($3000 per month,
after-tax). The appropriate formula is: =PV(0.14/12,60,3000)
2
Depreciation deductions found using the VDB function in Excel, as follows:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-59

The McGraw-Hill Companies 2008

20-55 (Continued)

The advantage of using the VDB function in Excel, rather than the DDB function, is
that there is a (default) option in the former that provides an automatic switch to the
SL method when it is advantageous to do so.
2. The positive NPV, $260,920, suggests that, compared to the leasing alternative, it is
financially advantageous to convert the facility into a factory outlet. The NPV from
converting the facility into a factory outlet is also better then the alternative of selling
the warehouse for $200,000 (see item b).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-60

The McGraw-Hill Companies 2008

20-56

Machine Replacement with Tax Considerations (30 - 45 min)

Present Value of Costs with the Original Equipment:


Present value of tax savings from depreciation deductions:
($2,500,000 4) x 0.45 x 2.577 =
Present value of cash operating costs:
[$1,800,000 x (1 0.45)] x 2.577 =
Present value of salvage value:
Present value of costs with the original equipment =

($724,781)
$2,551,230
$1,804,614

Present value of Costs with the New Machine:


Initial outlay cost
$2,000,000
Present value of tax savings from depreciation deductions:
Beginning
Depreciation Tax
Tax
Discount
Year Book Value
Expense1 Rate Savings
Factor
1
$2,000,000 $1,333,333 x 0.45 = $600,000 x 0.926 =
($555,600)
2
666,667
444,445 x 0.45 = 200,000 x 0.857 =
(171,400)
3
222,223
222,223 x 0.45 = 100,000 x 0.794 =
(79,400)
Cash proceeds from sale of the old machine
($300,000)
Tax savings related to loss on disposal of the old machine:
($1,875,0002 $300,000) x 0.45
=
($708,750)
Present value of cash operating costs: $1,000,000 x (1 0.45) x 2.577 = $1,417,350
Present value of costs with the new machine
$1,602,200
Notes:
1

DDB depreciation charges were calculated using the VDB function in Excel, as
follows:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-61

The McGraw-Hill Companies 2008

20-56 (Continued)
2

Book value of old asset at time of sale =


Original cost accumulated depreciation =
$2,500,000 [($2,500,000/4) x 1 year] =
$2,500,000 $625,000 = $1,875,000

PV of savings from using the new machine:


$1,804,614 $1,602,200 = $202,414
The total cost of the new machine, including the purchase cost and the cash
operating cost in each of the three years, is in present value terms $202,414 below
the total cost of continuing with the original equipment. Therefore, from a purely
financial standpoint, the purchase of the new machine is a good investment.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

20-62

The McGraw-Hill Companies 2008

20-57
1. a.

b.

Equipment Replacement (35 50 min)


Selling price per unit
Variable cost per unit:
Direct materials
Direct manufacturing labor
Indirect manufacturing costs
Contribution margin per unit

$30.00
$0.25 x 8 =
$8.00 x 2 =

$2.00
16.00
0.30

18.30
$11.70

The standard overhead application rate per unit, based on a normal capacity of
100,000 units per year, consists of a variable and a fixed cost component, as
follows:
$0.3 +

$25,000

= $0.55

100,000

c.

Current level of fixed overhead costs per year


Increase in equipment depreciation:
New equipment
($100,000 $10,000) 10 =
Current (SL) depreciation charges
Total budgeted fixed overhead costs per year

$25,000
$9,000
2,000

7,000
$32,000

New variable overhead cost per unit = old cost + $0.10 = $0.40.
= $32,000 + [$0.40 per unit x units manufactured]
d. Based on a normal capacity level of 100,000 units, the new overhead rate per unit
$32,000

+ $0.40 = $0.72

100,000

e.

Selling price per unit


Variable cost per unit:
Direct materials (unchanged)
Direct labor ($8 per hour x 1 hour)
Indirect manufacturing costs
Contribution margin per unit

Blocher, Stout, Cokins, Chen, Cost Management, 4/e

$30.00
$2.00
8.00
0.40

20-63

10.40
$19.60

The McGraw-Hill Companies 2008

20-57
f.

g.

2.

(Continued)
Net purchase price of new saw
Gross proceeds from selling the old saw
Tax savings from loss on disposal:
Book value of old saw (given)
$20,000
Selling price
4,000
Loss on sale
$16,000
Income-tax rate
0.40
Net additional investment required for the new saw
Expected net additional cash flow per year:
Increase in cm/unit = $19.60 11.70 =
$ 7.90
Number of units per year
x 100,000
Increase in total contribution margin before taxes
Less: Increase in income taxes = $790,000 x 40%
Increase in total contribution margin after taxes
Plus: Additional tax savings from depreciation = $7,000 x 0.4
Expected additional net cash inflow per year

$100,000
$4,000

6,400

=
=
=
=
=

10,400
$89,600

$790,000
316,000
$474,000
2,800
$476,800

With over forty percent of the households in the community having at least one
member working for the firm, the firm is a major employer of the community. Unless
alternative employment opportunities can be created, a fifty percent reduction in its
workforce will have a major impact on the economy of the community.
To remain competitive, the firm needs to upgrade its equipment. However, the
shareholders and management should not be the only beneficiaries from the
additional net cash inflows. Although the firm may be able to ease the pain of
layoffs by not filling positions vacated through retirement or resignation, a reduction
of one-half of its employment will definitely be a major blow to the community. Thus,
the firm needs to consider using the additional net cash inflows to create new job
opportunities for the labor force that will be reduced.

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20-58

Equipment Replacement with MACRS Depreciation (35 - 45 min)

1. Per-unit profit margin of the additional units:


Sales price per unit
Current manufacturing cost
Current gross margin per unit
Cost savings per unit with the new machine
Gross margin (cash flow) per unit for the additional units
Net cash inflows:
Present
Item Description
Value
Purchase cost
($608,000)
Installation cost
($12,000)
After-tax proceeds from disposing old
$30,000
Gross margin/unit (above)
Additional units
Pre-tax cash flow from additional units (000)
Efficiency savings (000)
Total increase in pre-tax incomes/cash flow (000)
Income taxes (000)
Increase in after-tax cash flow before depreciation (000)
After-tax proceeds from disposal ($80,000 x 0.6)
Tax savings from depreciation (000)
After-tax cash inflows
$155,243
$168,286
$97,516
$109,115
Net Present Value (NPV)
($59,840)

$3,500
2,450
$1,050
+
150
$1,200

Discount
Factor

0.870
0.756
0.658
0.572

2010

2011

2012

2013

$1,200
30
$ 36
125
$161
64.4
$96.60

$1,200
50
$ 60
125
$185
74
$111

$1,200
50
$ 60
125
$185
74
$111

81.84
$178.44

111.60

37.20

$1,200
70
$ 84
125
$209
83.6
$125.4
48
17.36

VacuTech can expect to have a negative NPV of $59,840 if it purchases the new pump.

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222.60
148.20
190.76

20-58 (Continued)
2. Other factors the firm needs to consider include:

Maintenance costs of the machines


Reliability of the machines
Changes and timing of newer machine
Effects on production workers
Learning effect on using the new machine
Changes in market
Competitor reaction

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20-59 Joint Venture (10 20 min)


Present value of net cash inflows (at risk-adjusted
discount rate of 20%, 10 years)
=
($900,000 x 0.8) x 4.192
Less: Initial investment outlay
=
3,000,000
NPV
=
$18,240
Yes. The group can expect a positive NPV of $18,240.
Note that the projected IRR of this project (20.18%) exceeds the minimum
required rate of return (20.00%), as follows:

This problem provides a good opportunity for the instructor to discuss why the
discount rate for certain types of investments (such as a joint venture in an
emerging economy) would likely exceed the organizations weighted-average cost
of capital (WACC). The appropriate risk adjustment, as noted in the text, is the
subject of advanced discussions in corporate finance textbooks.

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20-60
1.

Risk and NPV (45 min)


PV of future cash inflows @ 12% = $275,000 x 6.194 =
Less: Initial investment outlay, year 0
=
Net present value (NPV)
=

$1,703,350
$1,500,000
$ 203,350

Since the NPV > $0, the project should be accepted.


2.

PV of future cash inflows @ 15% = $275,000 x 5.421 =


Less: Investment outlay, year 0
=
Net present value (NPV)
=

$1,490,775
$1,500,000
$(9,225)

Since the NPV < $0, the project should not be accepted.
3.

The break-even initial investment outlay is the amount that would produce a
NPV = $0, given the annual after-tax flows of $275,000 and a discount rate of
15.00%. We can use Excel to solve, in two steps, for this break-even amount
= $1,490,670:
Step 1: Estimate the Projects NPV (compare with 2 above)

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20-60 (Continued)
Step 2: Complete the following goal seek dialog box:

4.

Many firms raise the discount rate in evaluating a particular capital investment
in view of uncertainties underlying the investment. This approach allows
managers to factor in risks and uncertainties. The higher the risk or uncertainty
a project has, the higher the discount rate.
An alternative is to use a direct approach in dealing with risk or uncertainty.
For example, if a firm considers that revenues from an investment are likely to
differ from the projected figures, the firm should adjust the projected revenues.
If the expenses are likely to be higher, adjusting the projected expenses would
allow the firm to be aware of the need for a higher amount of cash outflows.
Some believe that using a direct approach (if possible) is better than simply
using a higher discount rate. In any case, the topic of risk adjustments is
handled more completely in financial management textbooks.

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20-61
1.

Sensitivity Analysis (40 min)


NPV of proposed investment,15-year project life:
PV of after-tax cash inflows = $600,000 x 6.142 = $3,685,200
Since NPV = $185,200, the investment should be undertaken.
NPV of proposed investment, 12-year project life:
PV of after-tax cash inflows = $600,000 x 5.660 = $3,396,000
Since NPV = ($104,000), the investment should not be undertaken.

2.

We are given annual after-tax cash inflows of $600,000 and an initial


investment outlay of $3,500,000. To generate an IRR of exactly 14.00%, the
following must hold:
PV of Future Cash Inflows = Initial Investment Outlay
$600,000 x An,14% = $3,500,000
Thus, we need to solve for the particular n that balances the preceding
equation. An, 14% = $3,500,000/$600,000 = 5.833. This annuity factor, at 14%,
approximates a 13-year life (see Table 2, page 871). Therefore, the number of
years needed for the Seattle facility to earn at least a 14% return is
approximately 13 years.
Though not discussed in the text, we can solve exactly for the number of years,
n, once we know the formula to calculate the PV of an ordinary annuity (i.e., the
formula for the factors included in Table 2, page 871). This formula is:
Annuity Factor = [1/r * [1 [1/rn]], where n = the number of periods and r =
the discount rate (defined in terms of n, e.g., in years)
In the present case, the annuity factor = 5.83333 and r = 0.14. Thus, we have
5.83333 = [1/0.14] * [1 [1/(1.14)n]]
(1) First, divide both sides by (1/0.14), which yields:
0.8166662 = 1 (1/(1.14)n)
(2) Next, subtract 1 from both sides, to yield:
-0.1833338 = 1/(1.14)n

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20-61 (Continued)
(3) Multiply both sides by 1:
0.1833338 = 1/(1.14)n
(4) By rule of exponents (i.e., 1/xn = x-n), the right-hand side of the above
can be expressed as:
1/(1.14)n = 1.14-n
(5) This gives us:
0.1833338 = 1.14-n
(6) Take the log of each side of (5), which gives us:
log 0.1833338 = log 1.14-n
(7) Now, by a rule of logs the right-hand side of (6) can be
re-expressed as follows:
log 0.1833338 = n log 1.14
(8) Finally,
n = log 0.1833338/log 1.14
n = 12.94718
n = 12.9 years

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20-62 Uneven Cash Flows (40 min)


1.

Present value of net cash inflows:


Year 1

-0-

Year 2

$1,000,000 x 0.797 =

Year 3

$1,000,000 x 0.712 =

712,000

Year 4

$2,500,000 x 0.636 =

1,590,000

($3,000,000 x 4.111) x 0.636 =

7,843,788

Years 5-10

Present value of net cash inflows

797,000

$10,942,788

Less: Initial investment outlay, year 0

15,000,000

NPV (@12%)

$(4,057,212)

Alternatively, the built-in functions in Excel can be used to estimate the NPV
and the IRR of this project, as follows:

2. The maximum purchase price the seller would be willing to offer, given a
discount rate of 12% and the indicated cash flows, would be slightly less than
$11,000,000, as follows:

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20-62 (Continued)

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20-63
1.

Environmental Cost Management (60 - 75 min)

Solvent System

Initial investment

Present
Value
$400,000

After-tax paint cost

Year 1

Year 2

$228,000

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

$228,000 $228,000

$228,000

$228,000 $228,000 $228,000

$228,000

$228,000

$228,000

After-tax environ. costs

$383,845

$383,845 $383,845

$383,845

$383,845 $383,845 $383,845

$383,845

$383,845

$383,845

Total after-tax cash costs

$611,845

$611,845 $611,845

$611,845

$611,845 $611,845 $611,845

Year 11
0

$611,845

$611,845

$611,845

Depreciation (MACRS)

40,000

72,000

57,600

46,080

36,880

29,480

26,200

26,200

26,240

26,200

13,120

Tax saving on deprec.

16,000

28,800

23,040

18,432

14,752

11,792

10,480

10,480

10,496

10,480

5,248

$583,045 $588,805

$593,413

$597,093 $600,053 $601,365

Net after-tax cash costs

$595,845

Discount factor (12%)


Present value

3,360,365

Total cost

$3,760,365

Powder System
Initial investment

$1,200,000

After-tax paint cost


Depreciation (MACRS)

$601,349

$601,365

(5,248)

0.797

0.712

0.636

0.567

0.507

0.452

0.404

0.361

0.322

0.287

532,090

464,867

419,229

377,411

338,552

304,227

271,817

242,951

217,087

193,640

(1,506)

$240,000 $240,000 $240,000

$240,000

$240,000 $240,000 $240,000

$240,000

$240,000

$240,000

78,600

78,720

78,600

39,360

120,000

Tax saving on deprec.


Net after-tax cash costs
Discount factor (12%)
PV

$601,365

0.893

1,064,182

Total cost

$2,264,182

Difference in total cost

$1,496,183

216,000

172,800

138,240

110,640

88,440

78,600

48,000

86,400

69,120

55,296

44,256

35,376

31,440

31,440

31,488

31,440

15,744

192,000

153,600

170,880

184,704

195,744

204,624

208,560

208,560

208,512

208,560

(15,744)

0.893

0.797

0.712

0.636

0.567

0.507

0.452

0.404

0.361

0.322

0.287

171,456

122,419

121,667

117,472

110,987

103,744

94,269

84,258

75,273

67,156

(4,519)

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20-63 (Continued)
Notes:
(1) Annual after-tax paint cost, solvent system = $0.19/unit x 2,000,000 units/year x
(1 0.40) = $228,000.
(2) MACRS depreciation rates, 10-year property:

Year
1
2
3
4
5

Rate
10.00%
18.00%
14.40%
11.52%
9.22%

Year
6
7
8
9
10
11

Rate
7.37%
6.55%*
6.55%
6.56%
6.55%
3.28%

* first year switching to SL method


(3) Additional environmental costs, Solvent Paint System:
Item
Pit cleaning
Waste disposal
Superfund Fee
Worker training
Insurance
Amortization of air-emission permit
Air-emission fee
Recordkeeping
Wastewater treatment
Pre-tax Total
Times (1 - 0.40)
After-tax environmental costs

Annual Cost
$12,000
$549,000
$3,177
$3,000
$10,000
$200
$1,115
$11,250
$50,000
$639,742
x 0.60
$383,845

(4) Annual after-tax paint cost, Powder Paint System = $0.20/unit x 2,000,000
units/year x (1 0.40) = $240,000.
2. Based solely on financial considerations, the maximum the company should spend
on the Powder-Based System = original estimate + difference in PVs of costs (from
Part 1) = $1,200,000 + $1,496,183 = $2,696,183 (i.e., an increase of up to 125%
over the original price).

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