Professional Documents
Culture Documents
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,
Blocher, Stout, Cokins, Chen, Cost Management, 4/e
20-1
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
Blocher, Stout, Cokins, Chen, Cost Management, 4/e
20-2
20-3
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
Blocher, Stout, Cokins, Chen, Cost Management, 4/e
20-4
20-5
20-6
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.
20-7
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:
20-8
=
=
=
=
=
$70.00
24.50
$45.50
50.00
$95.50
$78.00
=
=
$17.50
$95.50
$10,000 x
$10,000 x
$10,000 x
$10,000 x
Sum
33.33% =
44.45% =
14.81% =
7.41% =
= $10,000
$3,333
$4,445
$1,481
$ 741
20-9
$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
20-11
Source of Funds
Long-term Debt
Preferred Stock
Common Stock
Market Value
$40
$20
$60
$120
(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%
EXERCISES
Payback Period
$5,000
$1,800
2.78 years
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
Payback Period
$5,000
$2,125
2.35 years
20-13
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
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
Project C:
Project D:
Present value of cash inflows:
Years 1 through 4
Year 5
Initial investment
Net present value (NPV)
20-14
$6,955
1,771
$8,726
5,000
$3,726
$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%
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%
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%
20-15
20-16
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
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
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
20-37 (Continued)
b. 1.
2.
5%
Discount Factor
2.362
2.362
2.230
2.166
0.196
0.132
25%
0.132
5% 28.37%
0.196
Or, using the IRR function in Excel, IRR = 28.27%:
20-18
20-38 Basic Capital Budgeting Techniques: Uniform Net cash inflows, No Income
Taxes, Non-MACRS-Based Depreciation (45 min)
a.
b.
On initial investment:
(2)
On average investment:
Average investment:
Book rate of return:
$70,000/$500,000 =
14.00%
20-19
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 +
$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
20-20
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
20-21
$125,000
= 4.68 year s
$183,000
20-39 (Continued)
b.
On initial investment:
$81,200/$500,000 = 16.24%
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)
18% +
20-22
$540,042 - $500,000
2% = 19.89%
$42,419
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
$60,920
$185,280
20-26
= 4.33 years
20-40 (Continued)
2. Book rate of return (ARR):
Average after-tax operating income/year:
$812,000/10 =
$81,200
$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
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
20-27
$8,000 $5,000 =
Tax rate
3,000
x
Income taxes
40%
$1,200
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.
$5,000 x 4.623 =
PV of salvage value
$ 600 x 0.63 =
378
$23,493
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)
20-28
20-42
Cash revenue
Tax saving on depreciation expense
Total
1. Payback period:
$6,000
$990
$780
210
$990
= 6.06 years
$1,200
600
$ 600
210
$ 390
Therefore,
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.
20-29
20-42 (Continued)
5.
PV Annuity
Factor
6.145
5.019
4.192
20-30
$1,080
20-31
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
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
20-33
(24.0)
19.2
(33.0)
30.0
20-44 (Continued-1)
NOTES
1
$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
Purchase price
Installation, testing, rearrangement, and training
Subtotal
$280,000
Trade-in allowance for AccuDril
Net purchase cost
$250,000
+
30,000
$24,000
40,000
$240,000
$48,000
0.40
$19,200
$33,000
$30,000
20-34
20-44 (Continued-2)
2.
Year
0
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
20-35
= $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%.
20-36
20-45 (Continued-1)
2. The beginning spreadsheet contains the PV of each alternative:
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):
20-37
20-45 (Continued-2)
20-38
20-45 (Continued-3)
3.
Discount
Factor
Present
Value
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)
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
4.0
(100.0)
3.6
4.0
4.0
4.0
20-45 (Continued-4)
1
$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.
20-40
20-46
(50
$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.
20-41
$210,000/$595,000
= 35.29%
20-46 (Continued-1)
5.
952,020
358,160
995,000
315,180
Thus, the estimated NPV of the investment = $315,078 (note the rounding error
that occurs when using the PV and annuity factors)
6.
$1,048,370
$ 956,310
$ 92,060
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:
20-42
20-46 (Continued-2)
20-43
20-47
1.
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.
3.
20-44
20-47 (Continued-1)
4.
Discount Factor
3.993
3.993
3.904
3.890
0.103
0.089
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%
?
Thus, the estimated IRR of the project equals approximately 11%, as follows:
IRR = 10% +
$2,857
$5,503
2% = 11.04%
20-45
20-47 (Continued-2)
Using Built-in Function in Excel: the projected IRR for this investment is 11.02%, as
follows:
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.
20-46
20-48
Capital
Budgeting
with
Sum-of-the-Years-Digits
Spreadsheet Application (25 min)
20-47
Depreciation;
20-49
($6,750
) (1 0.20)
10
0.10
Y
20-48
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
20-49
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
20-50
$12,000
($3,000)
$9,000
+ $12,000
$21,000
+ $3,000
$24,000
20-52
1. a.
b.
Depreciation:
Old
($5,000 $600)/11
New
($8,000 $400)/10
= $400
Difference
= $760
$360
($750)
$390
3/5/2018
Average Investment (Book Value)
Old
$4,600
New
$8,000
600
400
$2,600
$4,200
$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
20-51
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
4,940
Difference
$ 226
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
$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.)
20-52
20-53
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
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
-0-
$1,615
20-54
20-53
3.
(Continued)
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%
20-55
=
=
=
$700,000
210,000
$490,000
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.
=
=
=
=
=
20-56
20-57
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))
20-58
20-55
1.
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
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:
20-59
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).
20-60
20-56
($724,781)
$2,551,230
$1,804,614
DDB depreciation charges were calculated using the VDB function in Excel, as
follows:
20-61
20-56 (Continued)
2
20-62
20-57
1. a.
b.
$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.
$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.
$30.00
$2.00
8.00
0.40
20-63
10.40
$19.60
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.
20-64
20-58
$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.
20-65
222.60
148.20
190.76
20-58 (Continued)
2. Other factors the firm needs to consider include:
20-66
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.
20-67
20-60
1.
$1,703,350
$1,500,000
$ 203,350
$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)
20-68
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.
20-69
20-61
1.
2.
20-70
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
20-71
-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
7,843,788
Years 5-10
797,000
$10,942,788
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:
20-72
20-62 (Continued)
20-73
20-63
1.
Solvent System
Initial investment
Present
Value
$400,000
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
$383,845
$383,845 $383,845
$383,845
$383,845
$383,845
$383,845
$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
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
$595,845
3,360,365
Total cost
$3,760,365
Powder System
Initial investment
$1,200,000
$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
78,600
78,720
78,600
39,360
120,000
$601,365
0.893
1,064,182
Total cost
$2,264,182
$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)
20-74
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%
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).
20-75