CHAPTER 23

DISCUSSION QUESTIONS

Q23-1. The weighted average cost of capital is computed by the following steps:
(a) Calculate each component of capital as a
percentage of total capital.
(b) Calculate the after-tax cost of each individual capital component.
(c) For each capital component, multiply (a)
by (b) and sum the results.
Q23-2. Using the cost of a specific source of funds
may lead to faulty decisions. For example,
when debt is used, low-return projects would
be acceptable while better investments would
have to be ruled out in a following period, when
common stock shares are sold to obtain funds.
Q23-3. There are two problem areas associated with
estimating the firms weighted average cost of
capitalthe proportions of each source of
funds and the cost of each source of funds.
The proportions that are expected over the
investment horizon should be used. Since
these amounts are typically unknown, the
proportions desired by management in the
long run are usually used. With respect to
costs, the market prices of each source of
funds should be used. Since the market price
varies over time as creditor and investor
expectations change, current market prices
adjusted for changes expected by management are commonly used.
CGA-Canada (adapted). Reprint with permission.
Q23-4. The payback (or payout) period method measures the length of time required by a project
to recover the initial investment outlay.
Q23-5. In computing the accounting rate of return on
original investment, the denominator is the
original investment, whereas in computing
the accounting rate of return on average
investment, the denominator is the average
investment.
Q23-6. The present value concept states that a dollar
received today is worth more than a dollar to
be received at a future date because of the
earnings the today dollar can generate in the
interim. It is important in capital budgeting

because of the relatively long periods

between the investment of funds and the
return of those funds as earnings (i.e., dollars
returned a long time in the future are worth
considerably less than those invested today).
Q23-7. The basic difference between the payback
method and the net present value method concerns the recognition of the time value of
money. The payback method, which ignores
the time value of money and all cash flows
beyond the payback period for the project, is
the measure of the time it will take to recover
the initial capital investment in net cash inflows.
The net present value method does consider the time value of money. This method
involves comparing the present value of all
future cash inflows and outflows of a given
project, using some minimum desired rate of
return. A positive result implies that the projects rate of return exceeds this minimum rate,
whereas a negative result indicates that the
projects rate of return is less than this minimum rate.
Q23-8. In the net present value method, the discount
rate is known; whereas, in the internal rate of
return method, the discount rate is not known.
In the internal rate of return method, the discount rate is the one that will result in a net
present value of zero.
Q23-9. The net present value method assumes that
earnings are reinvested at a rate of return
equal to the firms cost of capital, whereas the
internal rate of return method assumes that
earnings are reinvested at the rate of return of
the particular project being considered. The
firms cost of capital rate is more realistic. If an
investment proposal is predicted to be
extremely profitable (e.g., having an internal
rate of return of 50%), it is unlikely that similar
proposals are available. However, a firm should
ordinarily have several investment opportunities at or near the rate of its cost of capital.
CGA-Canada (adapted). Reprint with permission.

23-1

23-2

Q23-10. Setting the discount rate at something in

excess of the cost of capital in order to compensate for risk and uncertainty associated
with a capital expenditure proposal is conceptually unsound, because the reinvestment
potential of cash flows is overstated. Cash
received in early periods has more value than
cash received in later periods, because only
the cash received in the early periods can be
reinvested. As a consequence, the use of a
rate in excess of the reinvestment rate in the
net present value method will result in an

Chapter 23

overstatement of the value of cash received

early in the life of the capital expenditure project. A better approach would be to compute
the terminal value of the cash flows using the
reinvestment rate (i.e., compute the value of
all cash flows at the end of the life of the project), and then discount the total to present
value at a risk-adjusted discount rate. An even
better approach is to explicitly consider uncertainty by using probability analysis, as discussed in Chapter 24.

Chapter 23

23-3

EXERCISES
E23-1
Proportion After-Tax Weighted
FundsSource
of Funds
Cost
Cost
Bonds (10% (1 45% tax rate)) .................................
30%
5.5%
1.65%
Preferred stock ...............................................................
10%
12.5% *
1.25%
Common stock and retained earnings.........................
60%
15.0% ** 9.00%
100%
11.90%
*(12% $100 par value for preferred stock) $96 market value
**($75,000 50,000 shares of common stock) $10 market price per share
E23-2
Weighted average cost of capital before bond retirement and sale-leaseback
transaction:
(1)

Capital Component
Bonds.....................
Preferred stock......
Common stock and
retained earnings

(2)

(3)

(4)

Amount
$ 5,000,000
1,000,000

Percent
of Total
50%
10%

Pretax
Cost
8.0%
9.0%

After-Tax
Cost
4.8%
9.0%

4,000,000
$10,000,000

40%
100%

12.5%

12.5%

(5)
Weighted
Cost
(2) (4)
2.4%
.9%
5.0%
8.3%

Weighted average cost of capital after bond retirement and sale-leaseback

transaction:
(1)

Capital Component
Lease......................
Bonds.....................
Preferred stock......
Common stock and
retained earnings

(2)

3)

(4)

Amount
$ 1,000,000
4,000,000
1,000,000

Percent
of Total
10%
40%
10%

Pretax
Cost
10.0%
8.0%
9.0%

After-Tax
Cost
6.0%
4.8%
9.0%

4,000,000
$10,000,000

40%
100%

12.5%

12.5%

(5)
Weighted
Cost
(2) (4)
.60%
1.92%
.90%
5.00%
8.42%

23-4

Chapter 23

E23-3
(1)

Annual cash inflow before income tax .......................... $15,000

Less depreciation (the same for financial accounting
and income tax purposes ($40,000 cost
8 years)) ......................................................................
5,000
Annual taxable income .................................................... $10,000
Annual income tax ($10,000 taxable income 40%) ....
4,000
Annual income after taxes .............................................. $ 6,000

$15,000

Annual after-tax cash inflow ...........................................

$11,000

4,000

$40,000 initial cash outflow = 3.636 years to payback

$11,000 annual cash inflow
(2)

$6,000 average annual income = .15 or 15% rate of return

$40,000 original investment
on original investment

E23-4
(1)

$33,000 initial cash outflow

$10,000 annual cash inflow

(2)

Present value of annual cash inflows for six years

($10,000 annual cash inflow 3.784)..............................
Less initial cash outflow to acquire investment ...........

(3)

= 3.3 years to payback

$37,840
33,000

Net present value of investment.....................................

4,840

Cash desired at end of six years....................................

Present value of $1 compounded annually at 15% ......

$33,000
.432

Investment required .........................................................

$14,256

E23-5
(1)

(2)

Present value of annual cash inflows for 10 years

($20,000 annual cash inflow 5.216)..............................
Present value of salvage value at end of 10-year life
($10,000 cash inflow from salvage .270)...............

$104,320
2,700

Present value of all cash inflows....................................

Less initial cash outflow to purchase press .................

$107,020
(99,000)

Net present value of investment.....................................

Present =
value index

$8,020 net present value

$99,000 initial investment

= .08101 or 8.1%

8,020

Chapter 23

23-5

E23-6
(1)

Year
1
2
3
4
5
6

(2)

MACRS StraightRecovery
Line
Rate
Rate
0.200
0.320
0.192
0.115
0.115
0.058

0.100
0.200
0.200
0.200
0.200
0.100

(3)

(4)

(5)

(6)

Cost
Recovery
Under
MACRS

StraightLine
Depreciation

Difference
(3) (4)

$ 20,000
32,000
19,200
11,500
11,500
5,800

$ 10,000
20,000
20,000
20,000
20,000
10,000

$10,000
12,000
(800)
(8,500)
(8,500)
(4,200)

$100,000

$100,000

(7)

Income
Tax
Present
Savings Value of
(5) 40% $1 @ 14%
$4,000
4,800
(320)
(3,400)
(3,400)
(1,680)

0.877
0.769
0.675
0.592
0.519
0.456

(8)
Present
Value of
Tax
Savings
(6) (7)
$3,508
3,691
(216)
(2,013)
(1,765)
(766)
$2,439

E23-7
(1)
Year
1
2
3
4
5

Unadjusted Estimate
of Cash Inflows
$20,000
18,000
16,000
10,000
10,000
$74,000

Inflation
Adjustment
1.10000*
1.21000
1.33100
1.46410
1.61051

Inflation
Adjusted Estimate
of Cash Inflows
$22,000.00
21,780.00
21,296.00
14,641.00
16,105.10
$95,822.10

*(1 + .10)n where n = number of periods

(2)
Unadjusted
Adjusted
PV of $1
Year
Cash Flows
Cash Flows
@ 15%
0
$(60,000)
$(60,000)
1.000
1
20,000
22,000
.870
2
18,000
21,780
.756
3
16,000
21,296
.658
4
10,000
14,641
.572
5
10,000
16,105
.497
Net present value of investment.................

PV of
Unadjusted
Cash Flows
$(60,000)
17,400
13,608
10,528
5,720
4,970
$ (7,774)

PV of
Adjusted
Cash Flows
$(60,000)
19,140
16,466
14,013
8,375
8,004
$ 5,998

23-6

Chapter 23

E23-8

Year
1
2
3
4
5
6
7
8

(1)

Year
1
2
3
4
5
6
7
8
9
10

Annual
Pretax
Cash
Inflows

(1)

(2)

Tax
Basis
of New
Airplane
$500,000
500,000
500,000
500,000
500,000
500,000
500,000
500,000

7-Year
Property
Recovery
Rate
0.143
0.245
0.175
0.125
0.089
0.089
0.089
0.045

(2)

(3)
Increase
(Decrease)
Tax
in
DepreTaxable
ciation
Income
Deduction
(1) (2)

$130,000 $ 71,500
130,000 122,500
130,000
87,500
130,000
62,500
130,000
44,500
130,000
44,500
130,000
44,500
130,000
22,500
130,000
0
130,000
0

$ 58,500
7,500
42,500
67,500
85,500
85,500
85,500
107,500
130,000
130,000

(4)

Income
Tax
Rate
40%
40%
40%
40%
40%
40%
40%
40%
40%
40%

(5)
Increase
(Decrease)
in
Income
Tax
(3) (4)
$23,400
3,000
17,000
27,000
34,200
34,200
34,200
43,000
52,000
52,000

(3)
Tax
Depreciation
on New
Airplane
(1) (2)
$ 71,500
122,500
87,500
62,500
44,500
44,500
44,500
22,500
$500,000
(6)

(7)

After-Tax
Cash
Inflows
(1) (5)

Present
Value
of $1
@ 15%

$106,000
127,000
113,000
103,000
95,800
95,800
95,800
87,000
78,000
78,000

0.870
0.756
0.658
0.572
0.497
0.432
0.376
0.327
0.284
0.247

(8)
Present
Value of
After-Tax
Cash
Inflows
(6) (7)
$ 92,742
96,012
74,354
58,916
47,613
41,386
36,021
28,449
22,152
19,266

Present value of periodic after-tax cash inflows ..................................................................

Plus present value of after-tax salvage ($100,000 (1 40%) .247) ................................

$516,911
14,820

Present value of cash inflows over useful life of new airplane............................................

Less initial cash outflow (cost of new airplane) ....................................................................

$531,731
500,000

Net present value of investment ..............................................................................................

$ 31,731

Chapter 23

23-7

E23-9
Cost of new machine .......................................................................................
Trade-in allowance for old machine................................................................
Net cash outflow at beginning of project.......................................................
Tax basis of old machine traded in ................................................................
Tax basis of new machine ...............................................................................

$38,000
18,000
$20,000
16,000
$36,000

Annual cost of operating old machine ...........................................................

Annual cost of operating new machine .........................................................
Annual cost savings with new machine.........................................................

$40,000
34,000
$6,000

Year
1
2
3
4
5

(1)
Original
Tax
Basis
of Old
Machine
$20,000
20,000
20,000
20,000
20,000

(2)
5-Year
Property
Recovery
Rate
0.320 *
0.192
0.115
0.115
0.058

(3)
Tax
Depreciation
on Old
Machine
(1) (2)
$ 6,400
3,840
2,300
2,300
1,160
$16,000

*Note that year 1 is actually the second year the old property is depreciated. Therefore,
the recovery rate for the second year is used to compute the amount of depreciation
on the old property in the first year of the capital expenditure proposal.

Year
1
2
3
4
5
6

(1)
Original
Tax
Basis
of New
Machine
$36,000
36,000
36,000
36,000
36,000
36,000

(2)
5-Year
Property
Recovery
Rate
0.200
0.320
0.192
0.115
0.115
0.058

(3)
Tax
Depreciation
on New
Machine
(1) (2)
$ 7,200
11,520
6,912
4,140
4,140
2,088
$36,000

23-8

Chapter 23

E23-9 (Concluded)
(1)

(2)

Allowable Tax Depreciation

New
Old
Year
Machine Machine
1
2
3
4
5
6

$ 7,200
11,520
6,912
4,140
4,140
2,088

$6,400
3,840
2,300
2,300
1,160
0

(3)
Additional
Tax
Depreciation
with New
Machine
(1) (2)
$ 800
7,680
4,612
1,840
2,980
2,088

(4)

(5)

Annual
Cost
Savings
With
New
Machine

Increase
(Decrease)
in
Taxable
Income
(4) (3)

$6,000
6,000
6,000
6,000
6,000
6,000

$ 5,200
(1,680)
1,388
4,160
3,020
3,912

(6)

(7)

Increase
(Decrease)
in
Income
Income
Tax
Tax
Rate
(5) (6)
40%
40%
40%
40%
40%
40%

$2,080
(672)
555
1,664
1,208
1,565

(8)

Net
Cash
Inflow
(4) (7)
$ 3,920
6,672
5,445
4,336
4,792
4,435

Total increase in periodic cash inflow ........................................................................................

Less initial cash outlay for new machine ...................................................................................

$29,600
20,000

Increase in cash inflows over initial cash outlay for new machine .........................................

$ 9,600

Year
0
1
2
3
4
5
6

(1)

(2)

Net
After-Tax
Cash
Inflow
(Outflow)
$(20,000)
3,920
6,672
5,445
4,336
4,792
4,435

Present
Value
of $1
@ 12%
1.000
0.893
0.797
0.712
0.636
0.567
0.507

(3)
Present
Value
of Cash
Flows
@ 12%
(1) (2)
$(20,000)
3,501
5,318
3,877
2,758
2,717
2,249
$
420

(4)

Present
Value
of $1
@ 14%
1.000
0.877
0.769
0.675
0.592
0.519
0.456

(5)
Present
Value
of Cash
Flows
@14%
(1) (4)
$(20,000)
3,438
5,131
3,675
2,567
2,487
2,022
$ (680)

$420
Internal rate of return = 12% + 2%
= 12.76%
$420 + $680

Recommendation: The investment may be acceptable because the internal rate of

return exceeds the companys cost of capital; however, the internal rate of return on
this project should be compared with the internal rate of return for other projects to
determine if this is the best use of available funds.

Chapter 23

23-9

E23-10
(1)
Project A
Cash Inflow
PV of $1
Year
(Outflow)
@15%
0
$(15,000)
1.000
1-5
5,000
3.352
Net present value ...................................................................

PV of
Cash Flow
$(15,000)
16,760
$ 1,760

Project B
Cash Inflow
PV of $1
Year
(Outflow)
@15%
0
$(15,000)
1.000
5
35,000
.497
Net present value ...................................................................
(2)

Project A
Year
0
1-5

Cash Inflow
(Outflow)
$(15,000)
5,000

PV of $1
@18%
1.000
3.127

PV of
Cash Flow
$(15,000)
15,635
$635

PV of $1
@20%
1.000
2.991

PV of
Cash Flow
$(15,000)
17,395
$ 2,395
PV of
Cash
Flow
$(15,000)
14,955
$
(45)

$635
Internal rate = 18% + 2%

= 18% + (2% .934 ) = 19.87%

of return
$635 + $45

Project B
Year
0
5

Cash Inflow
(Outflow)
$(15,000)
35,000

PV of $1
@18%
1.000
.437

PV of
Cash Flow
$(15,000)
15,295
$295

PV of $1
@20%
1.000
.402

PV of
Cash
Flow
$(15,000)
14,070
$(930)

$295
Internal rate = 18% + 2%

= 18% + (2% .241) = 18.48%

of return
$295 + $930

(3)

Using the internal rate of return method, Project A is superior to Project B. Using
the net present value method, Project B is more attractive than A. The decision
hinges on assumptions made about reinvestment of cash inflow. Theory suggests resorting to the net present value method because the cost of capital reinvestment assumption implicit in this method is considered more realistic than
the internal rate of return method, where a reinvestment at the projects internal
rate is assumed.

23-10

Chapter 23

PROBLEMS
P23-1
(1)
Alternative
Plan
(a)
(b)

Weighted
Average
Cost
7.20%

Source of
Financing
Debt

Portion of
After-Tax Cost
Total Required
12% (1 40% tax rate) $10,000,000
$10,000,000

Debt

12% (1 40% tax rate)

$5,000,000
$10,000,000

3.60%

9%
(1 4% issue cost)

$5,000,000
$10,000,000

4.69%

Preferred
stock

8.29%

(c)

(2)
Source of
Financing
Debt
Preferred stock
Common stock

Common
stock

$2.10 earnings per share

$10,000,000

11.05%

($20 (1 5% issue cost)) $10,000,000

Portion of
Current Total
$20,000,000
$90,000,000
9%
$10,000,000
$90,000,000
$2.10 earnings per share $60,000,000*
$20 market price per share $90,000,000
After-Tax Cost
10% (1 40% tax rate)

Weighted
Average
Cost
1.33%
1.00%
7.00%
9.33%

*3,000,000 shares outstanding $20 market price per share

Chapter 23

23-11

P23-1 (Concluded)
(3)
Alternative
Plan
(a)

(b)

(c)

Source of
Financing
After-Tax Cost
Marginal cost
7.20%
(from part (1))............
Current cost
9.33%
(from part (2)) ............
Total cost ....................
Marginal cost

Portion of
Total Required
$ 10,000,000
$100,000,000
$ 90,000,000
$100,000,000

Weighted
Average
Cost
.72%
8.40%
9.12%

8.29%

$ 10,000,000

.83%

(from part (1)) ............

Current cost
9.33%
(from part (2)) ............
Total cost ....................

$100,000,000
$ 90,000,000
$100,000,000

8.40%

Marginal cost
11.05%
(from part (1)) ............
Current cost
9.33%
(from part (2)) ............
Total cost ...................

$ 10,000,000
$100,000,000
90,000,000
$100,000,000

9.23%
1.11
8.40%
9.51%

23-12

Chapter 23

P23-2
Appraised value of the property, excluding storage tank and
water well ...............................................................................
Replacement cost of storage tank ..........................................

$100,000
250,000
$350,000

Differential cost of water resulting from loss of well:

Year

20A
20B
20C
20D
20E
20F
20G
20H

Water from City

of Darnett
at 8% Annual
Increase

Water from City

of Grant Well
MainAt 8%
tenance
Annual
and
Increase
Repair

Difference

Present
Value of
$1@ 10%

$ 72,720
$ 35,200
$ 37,520
.909
78,538
38,018
40,522
.826
84,821
41,057
43,764
.751
91,606
44,342
47,264
.683
98,935
47,889
$20,000
31,046
.621
106,850
51,720
20,000
35,130
.564
115,398
55,858
20,000
39,540
.513
124,629
60,327
20,000
44,302
.467
$773,497
$374,409
$80,000
$319,088
Estimated land value..........................................................................

Present
Value

$ 34,106
33,471
32,867
32,281
19,280
19,813
20,284
20,689
$212,791
$552,791

The City of Grant must also consider the offsetting increase in property and sales taxes
arising from the ongoing economic health of this part of the total business activity that
occurs within the city. This consideration may cause the negotiated land price to be
reduced. Of course, the uncertainty of the various estimates must be recognized.
P23-3
(1)

Project 1
PV of
Project 2
PV of
PV of $1
After-Tax
Project 1
After-Tax
Project 2
Year
@12%
Cash Flows Cash Flows Cash Flows Cash Flows
0
1.000
$(120,000)
$(120,000)
$(120,000) $(120,000)
1
.893
10,000
8,930
50,000
44,650
2
.797
20,000
15,940
45,000
35,865
3
.712
30,000
21,360
35,000
24,920
4
.636
60,000
38,160
25,000
15,900
5
.567
90,000
51,030
20,000
11,340
Net present value ....................... $ 15,420
$ 12,675

Chapter 23

23-13

P23-3 (Continued)
(2)

Project 1
After-Tax
PV of $1
Year Cash Flows
@14%
0
$(120,000)
1.000
1
10,000
.877
2
20,000
.769
3
30,000
.675
4
60,000
.592
5
90,000
.519
Net present value.......................

PV of
Cash Flows
$(120,000)
8,770
15,380
20,250
35,520
46,710
$6,630

PV of $1
@ 16%
1.000
.862
.743
.641
.552
.476

PV of
Cash Flows
$(120,000)
8,620
14,860
19,230
33,120
42,840
$(1,330)

$6, 630
= 15.67%
Project 1 internal rate of return = 14% + 2%
($6, 630 + $1, 330)

Project 2
After-Tax
PV of $1
Year Cash Flows
@ 16%
0
$(120,000)
1.000
1
50,000
.862
2
45,000
.743
3
35,000
.641
4
25,000
.552
5
20,000
.476
Net present value.......................

PV of
Cash Flows
$(120,000)
43,100
33,435
22,435
13,800
9,520
$2,290

PV of $1
@ 18%
1.000
.847
.718
.609
.516
.437

PV of
Cash Flows
$(120,000)
42,350
32,310
21,315
12,900
8,740
$(2,385)

$2, 290
= 16.98%
Project 2 internal rate of return = 16% + 2%
($2, 290 + $2, 385)

23-14

Chapter 23

P23-3 (Concluded)
(3)

The net present value of Project 1 is greater than the net present value of Project
2 ($15,420 compared to $12,675); however, the internal rate of return for Project
1 is less than the internal rate of return for Project 2 (15.67% compared to
16.98%). As a result, it is not altogether clear which project is the more profitable.
The difference in rankings occurs because of the difference in the pattern of
cash flows; i.e., the cash inflows for Project 1 are smaller in early years and
larger in later years than those of Project 2. The internal rate of return for Project
2 is substantially larger than the companys weighted average cost of capital. It
may not be possible for the cash flows received in early years to be reinvested
at a rate of return equal to the internal rate of return of Project 2; consequently,
cash flows received from Project 2 may not be as valuable to the firm as indicated by the internal rate of return. On the other hand, the weighted average cost
of capital is a realistic earnings rate expected by the company over the investment horizon. Assuming that there is no difference in the riskiness of the
expected cash flows for the two projects, it may be safer to rely on the net present value ranking than the internal rate of return. This would mean that Project 1
should be selected.

P23-4
(1)

Recovery of
Initial Outlay

After-Tax
Year
Cash Inflow
Needed
Balance
1
$300,000
$2,200,000
$1,900,000
2
350,000
1,900,000
1,550,000
3
400,000
1,550,000
1,150,000
4
450,000
1,150,000
700,000
5
500,000
700,000
200,000
6
550,000
200,000
0
Total payback in years ..................................................................
(2)

Net after-tax cash inflows .....................................................

Less depreciation ..................................................................
Net income over economic life of asset ..............................

Payback Years
Required
1.00
1.00
1.00
1.00
1.00
.36
5.36
$5,250,000
2,200,000
$3,050,000

Net income
Accounting rate of return =
Original investment
Economic
life

on original investment
$3, 050, 000
=
$2, 200, 000 = 13.9%
10 years

Chapter 23

23-15

P23-4 (Concluded)
(3)

Net income
Accounting rate of return =
Average investment
Economic life
on average investment
$3, 050, 000 $2, 200, 000
=

= 27.7%

0 years
2
10

(4)
Cash Inflow
PV of $1
Year
(Outflow)
@14%
0
$(2,200,000)
1.000
1
300,000
.877
2
350,000
.769
3
400,000
.675
4
450,000
.592
5
500,000
.519
6
550,000
.456
7
600,000
.400
8
650,000
.351
9
700,000
.308
10
750,000
.270
Net present value................................................

(5)

Cash
Inflow
Year
Outflow
0 $(2,200,000)
1
300,000
2
350,000
3
400,000
4
450,000
5
500,000
6
550,000
7
600,000
8
650,000
9
700,000
10
750,000

PV of $1
PV of
@ 16%
Cash Flow
1.000
$(2,200,000)
.862
258,600
.743
260,050
.641
256,400
.552
248,400
.476
238,000
.410
225,500
.354
212,400
.305
198,250
.263
184,100
.227
170,250
$
51,950

PV of
Cash Flow
$(2,200,000)
263,100
269,150
270,000
266,400
259,500
250,800
240,000
228,150
215,600
202,500
$ 265,200

PV of $1
PV of
@ 18%
Cash Flow
1.000 $(2,200,000)
.847
254,100
.718
251,300
.609
243,600
.516
232,200
.437
218,500
.370
203,500
.314
188,400
.266
172,900
.225
157,500
.191
143,250
$ (134,750)

Internal rate
$51, 950

= 16% + (2% .278) = 16.6%

=
16
%
+
2
%

of return
($51, 950 + $134, 750)

23-16

Chapter 23

P23-5
(1)

Machine 1
Total payback in years =

Initial outlay
$500, 000
=
= 4 years
Uniform cash inflows $125, 000

Machine 2
Recovery of
Initial Outlay
After-Tax
Year
Cash Inflow
Needed
Balance
1
$ 50,000
$600,000
$550,000
2
75,000
550,000
475,000
3
100,000
475,000
375,000
4
125,000
375,000
250,000
5
150,000
250,000
100,000
6
200,000
100,000
0
Total payback in years................................................
(2)

Machine 1
Net after-tax cash inflows. ..................................................
Less depreciation ................................................................
Net income over economic life of Machine 1....................
Accounting rate of return
on original investment

Payback Years
Required
1.00
1.00
1.00
1.00
1.00
.50
5.50

$1,000,000
500,000
$500,000

Net income
=
Original investment
Economic life
$500,000
=
$500,000 = 12.5%
8 years

Machine 2
Net after-tax cash inflows ...................................................
Less depreciation ................................................................
Net income over economic life of Machine 2....................
Accounting rate of return $800,000
=
$600,000 = 16.7%
on original investment
8 years

$1,400,000
600,000
$800,000

Chapter 23

23-17

P23-5 (Continued)
(3)

(4)

Machine 1
Accounting rate of return
on average investment

Net income
=
Average investment
Economic life
$500, 000 $500, 000
=

= 25%

2
8 years

Machine 2
Accounting rate of return
on average investment

$800,000 $600,000
=

= 33.3%

2
8 years

Machine 1
Cash Inflow
PV of $1
Year
(Outflow)
@15%
0
$(500,000)
1.000
1-8
125,000
4.487*
Net present value of Machine 1...........................

PV of
Cash Flow
$(500,000)
560,875
$60,875

*Present value of $1 received annually for 8 years from Table 23-2 of the text.
Machine 2
Cash Inflow
PV of $1
Year
(Outflow)
@15%
0
$(600,000)
1.000
1
50,000
.870
2
75,000
.756
3
100,000
.658
4
125,000
.572
5
150,000
.497
6
200,000
.432
7
300,000
.376
8
400,000
.327
Net present value of Machine 2 ...........................
Net present value index for Machine 1 = Net present value
Initial cash outlay
= $60,875
= .122
$500,000
Net present value index for Machine 2 =

$42,050 = .070
$600,000

PV of
Cash Flow
$(600,000)
43,500
56,700
65,800
71,500
74,550
86,400
112,800
130,800
$42,050

23-18

Chapter 23

P23-5 (Concluded)
(5)

Machine 1

Year
0
1-8

Cash Inflow
(Outflow)
$(500,000)
125,000

PV of $1
@18%
1.000
4.078

PV of
Cash Flow
$(500,000)
509,750
$ 9,750

PV of $1
@20%
1.000
3.837

PV of
Cash
Flow
$(500,000)
479,625
$ (20,375)

PV of $1
@18%
1.000
.847
.718
.609
.516
.437
.370
.314
.266

PV of
Cash
Flow
$(600,000)
42,350
53,850
60,900
64,500
65,550
74,000
94,200
106,400
$ (38,250)

$9, 750
Internal rate = 18% +
2%

of return
$9, 750 + $20, 375

= 18% + ( 2% .324 ) = 18.6

6%
Machine 2

Year
0
1
2
3
4
5
6
7
8

Cash Inflow
(Outflow)
$(600,000)
50,000
75,000
100,000
125,000
150,000
200,000
300,000
400,000

PV of $1
@16%
1.000
.862
.743
.641
.552
.476
.410
.354
.305

PV of
Cash Flow
$(600,000)
43,100
55,725
64,100
69,000
71,400
82,000
106,200
122,000
$ 13,525

$13, 525
Internal rate = 16% +
2%

of return
$13, 525 + $38, 250

= 16% + ( 2% .261) = 16.5%

Chapter 23

23-19

P23-6

Year
1
2
3
4
5
6
7

(2)
(3)
Cash
Savings Cash Flow
From
from
Reduced Increased
Maintenance Capacity
$1,500
1,200
900
600
300
0
0

$ 6,300
7,280
17,188
25,260
25,560
22,912
22,500

(4)

(5)

(6)

(7)

(8)

Total
Cash
Flow
(2) + (3)

Tax
Depreciation*

Taxable
Income
(Loss)
(4) (5)

Taxes
(6) 40%

After-tax
Cash
Flow
(4) (7)

$ 7,800
8,480
18,088
25,860
25,860
22,912
22,500

$10,800
17,280
10,368
6,210
6,210
3,132
0

$ (3,000)
(8,800)
7,720
19,650
19,650
19,780
22,500

$(1,200)
(3,520)
3,088
7,860
7,860
7,912
9,000

9,000
12,000
15,000
18,000
18,000
15,000
13,500

$100,500
Cash inflow from salvage at end of economic life, net of tax
($6,000 salvage (1 .40 tax rate)) ...................................................................

3,600

Total after-tax cash inflows ................................................................................

$104,100

*The tax depreciation is determined by multiplying the depreciable basis of $54,000 (i.e., the
cash purchase price plus the tax basis of zero) by the MACRS percentages provided in Exhibit
22-4 of the text for the five-year property class.

(1)
Recovery of
Initial Outlay
After-Tax
Year
Cash Inflow
Needed
Balance
1
$ 9,000
$54,000
$45,000
2
12,000
45,000
33,000
3
15,000
33,000
18,000
4
18,000
18,000
0
Total payback in years................................................
(2)

Net after-tax cash inflows (excluding salvage)..................

Less financial accounting depreciation
($54,000 cash + $4,000 book value $6,000 salvage)
Less tax on salvage ($6,000 salvage .40 tax rate)..........
Net income over the life of the property............................

Payback Years
Required
1
1
1
1
4
$100,500
52,000
$ 48,500
2,400
$ 46,100

23-20

Chapter 23

P23-6 (Concluded)
Accounting rate of return
on original investment

Net income
=
Original Investment
Economic life
$46, 100
=
$58, 000 = 11.35%
7 years

Accounting rate of return

on average investment

Net income
=
Average Investment
Economic life
$46, 100 $58, 000 + $6, 000
=

= 20.58%

2
7 years

(3)

Cash Inflow
PV of $1
Year
(Outflow)
@12%
0
$(54,000)
1.000
1
9,000
.893
2
12,000
.797
3
15,000
.712
4
18,000
.636
5
18,000
.567
6
15,000
.507
7
17,100*
.452
Net present value ................................................

PV of
Cash Flow
$(54,000)
8,037
9,564
10,680
11,448
10,206
7,605
7,729
$ 11,269

*$13,500 cash inflow in year 7 plus $3,600 after-tax salvage.

Net present value index = $11,269
= . 209
$54,000
(4)

Year
0
1
2
3
4
5
6
7

Cash
Inflow
(Outflow)
$(54,000)
9,000
12,000
15,000
18,000
18,000
15,000
17,100 *

PV of $1
@ 16%
1.000
.862
.743
.641
.552
.476
.410
.354

PV of
Cash Flows
$(54,000)
7,758
8,916
9,615
9,936
8,568
6,150
6,053
$ 2,996

PV of $1
@ 18%
1.000
.847
.718
.609
.516
.437
.370
.314

*$13,500 cash inflow in year 7 plus $3,600 after-tax salvage.

$2, 996
= 17.688%
Internal rate of return = 16% + 2%
($2, 996 + $553)

PV of
Cash Flows
$(54,000)
7,623
8,616
9,135
9,288
7,866
5,550
5,369
$ (553)

Chapter 23

23-21

P23-7

Year
1
2
3
4
5
6
7
8
9
10

Recovery
Year
1
2
3
4
5
6
7
8

(1)

(2)

Periodic
Net Cash
Inflows
$ 20,000
25,000
30,000
30,000
30,000
30,000
25,000
20,000
15,000
10,000
$235,000

Annual 7%
Price-Level
Adjustment
(1 + .07) = 1.070
(1 + .07)2 = 1.145
(1 + .07)3 = 1.225
(1 + .07)4 = 1.311
(1 + .07)5 = 1.403
(1 + .07)6 = 1.501
(1 + .07)7 = 1.606
(1 + .07)8 = 1.718
(1 + .07)9 = 1.838
(1 + .07)10 = 1.967

(1)

(2)
7-Year
Property
Recovery
Percentage
0.143
0.245
0.175
0.125
0.089
0.089
0.089
0.045

Depreciable
Basis of
Machine
$100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000

(3)
Adjusted
Estimate of
Net Cash
Inflows
(1) (2)
$ 21,400
28,625
36,750
39,330
42,090
45,030
40,150
34,360
27,570
19,670
$334,975

(3)
Tax
Depreciation
(1) (2)
$ 14,300
24,500
17,500
12,500
8,900
8,900
8,900
4,500
$100,000

23-22

Chapter 23

P23-7 (Continued)
(1)

(4)
(5)
(6)
Federal
Income
Net
Adjusted
Taxable
and
Tax
After-Tax
Estimate of
Tax
Income
State
Payment
Cash
Net Cash Deprec(Loss)
Income
(Reduction) Inflows
Year
Inflows
iation
(1) (2)
Tax Rate
(3) (4)
(1) (5)
1
$21,400
$14,300
$ 7,100
40%
$ 2,840
$ 18,560
2
28,625
24,500
4,125
40%
1,650
26,975
3
36,750
17,500
19,250
40%
7,700
29,050
4
39,330
12,500
26,830
40%
10,732
28,598
5
42,090
8,900
33,190
40%
13,276
28,814
6
45,030
8,900
36,130
40%
14,452
30,578
7
40,150
8,900
31,250
40%
12,500
27,650
8
34,360
4,500
29,860
40%
11,944
22,416
9
27,570
0
27,570
40%
11,028
16,542
10
19,670
0
19,670
40%
7,868
11,802
Total inflation-adjusted after-tax cash inflows ................................................ $240,985
(1)

(2)

(3)

Payback period:
Recovery of
Initial Cash Outlay
Net After-Tax
Year
Cash Inflow
Needed
Balance
1
$18,560
$100,000
$81,440
2
26,975
81,440
54,465
3
29,050
54,465
25,415
4
28,598
25,415
0
Total payback period in years............................................

(2)

Accounting rate of return on original investment:

Total inflation-adjusted after-tax cash inflow............................
Less financial accounting depreciation ....................................
Net income over economic life of project .................................

Average
annual return

Years Required
Until Payback
1.0
1.0
1.0
0.9
3.9

$240,985
100,000
$140,985

= Net income = $140,985 = $14,099

Economic life
10 years

Accounting rate
of return on original = Average annual return = $14,099 = .1410 or 14.10%
investment
Original investment
$100,000

Chapter 23

23-23

P23-7 (Continued)
(3)

Accounting rate of return on average investment:

Accounting rate of
return on average = Average annual return = $14,099 = .2820 or 28.20%
investment
Original investment 2
$50,000

(4)

Net present value and net present value index:

(1)
(2)
Net
After-Tax
Present
Cash
Value
(Outflow)
of $1
Year
Inflow
@ 15%
0
$(100,000)
1.000
1
18,560
0.870
2
26,975
0.756
3
29,050
0.658
4
28,598
0.572
5
28,814
0.497
6
30,578
0.432
7
27,650
0.376
8
22,416
0.327
9
16,542
0.284
10
11,802
0.247
Net present value ......................................
Net present =
value index

(5)

(3)
Present
Value of
Net Cash
Flow
(1) (2)
$(100,000)
16,147
20,393
19,115
16,358
14,321
13,210
10,396
7,330
4,698
2,915
$ 24,883

Net present value = $24,883 = .249

Required investment
$100,000

Present value payback in years:

Recovery of
Present
Initial Cash Outlay
Value of
After-Tax
Year
Cash Inflow
Needed
Balance
1
$16,147
$100,000
$83,853
2
20,393
83,853
63,460
3
19,115
63,460
44,345
4
16,358
44,345
27,987
5
14,321
27,987
13,666
6
13,210
13,666
456
7
10,396
456
0
Total payback period in years ........................................................

Years
Required
for Present
Value Payback
1.00
1.00
1.00
1.00
1.00
1.00
0.04
6.04

23-24

Chapter 23

P23-7 (Concluded)
(6)

Internal rate of return:

(1)

Year
0
1
2
3
4
5
6
7
8
9
10

Net
After-Tax
Cash
(Outflow)
Inflow
$(100,000)
18,560
26,975
29,050
28,598
28,814
30,578
27,650
22,416
16,542
11,802

(2)

Present
Value
of $1
@ 20%
1.000
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162

(3)
(4)
Present
Value of
Cash Flow Present
Discounted Value
@20%
of $1
(1) (2)
@ 22%
$(100,000)
1.000
15,460
0.820
18,721
0.672
16,820
0.551
13,784
0.451
11,583
0.370
10,244
0.303
7,714
0.249
5,223
0.204
3,209
0.167
1,912
0.137
$ 4,670

(5)
Present
Value of
Cash Flow
Discounted
@ 22%
(1) (4)
$(100,000)
15,219
18,127
16,007
12,898
10,661
9,265
6,885
4,573
2,763
1,617
$ (1,985)

Internal rate

$4, 670
of return = 20% + 2% $4, 670 + $1, 985 = .2140 or 21.4%

P23-8
(1)
(1)

(2)

Reduced Reduced
Labor
Machine
Year Cost
Setup Time
1
2
3
4
5
6

$15,000
25,000
30,000
30,000
30,000
30,000

$40,000
50,000
60,000
60,000
60,000
60,000

(3)
Reduced
Inventory
Carrying
Cost
$25,000
35,000
40,000
40,000
40,000
40,000

(4)

(5)
Total
Lost
Periodic
Contribution Savings from
Margin
CIM System
Avoided (1) + (2) + (3) + (4)
$200,000
300,000
400,000
500,000
600,000
700,000

$280,000
410,000
530,000
630,000
730,000
830,000

(6)

(7)
Net Periodic
Additional
Savings
Maintenance
with CIM
Cost with
System
CIM System
(5) (6)
$25,000
25,000
25,000
25,000
25,000
25,000

$255,000
385,000
505,000
605,000
705,000
805,000

Chapter 23

23-25

P23-8 (Continued)
(7)

(8)

Year

Net
Periodic
Savings
with CIM

Tax
Depreciation
and
Amortization*

1
2
3
4
5
6

$255,000
385,000
505,000
605,000
705,000
805,000

$440,000
680,000
424,000
270,000
270,000
116,000

(9)

(10)

Taxable
Income
(Loss)
(7) (8)

Effective
Tax
Rate

$(185,000)
(295,000)
81,000
335,000
435,000
689,000

40%
40%
40%
40%
40%
40%

(11)

(12)

(13)

Tax
Liability
(Refund)
(9) (10)

Periodic
Net
After-Tax
Cash
Inflows
(7) (11)

Index for
Anticipated
8% Rate
of
Inflation

(14)
InflationAdjusted
Periodic
Net AfterTax Cash
Inflows
(12) (13)

$ (74,000)
(118,000)
32,400
134,000
174,000
275,600

$329,000
503,000
472,600
471,000
531,000
529,400

1.080
1.166
1.260
1.360
1.469
1.587

$ 355,320
586,498
595,476
640,560
780,039
840,158

Total annual inflation-adjusted after-tax savings from investment in CIM system

Cash inflow from salvage of equipment and machinery
($100,000 salvage 1.587 adj. (1 40% tax rate)) .....................................................

$3,798,051

Total inflation-adjusted after-tax cash inflows from investment in CIM system. ............
Less initial investment ($2,000,000 in equipment plus $200,000 in software).................

$3,893,271
2,200,000

Excess of inflation-adjusted after-tax savings over cost of CIM system.........................

$1,693,271

(1)

Year
1
2
3
4
5
6

(2)

(3)

Rate for
Recovery MACRS
Property
5-year
Tax Basis Property
$2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000

0.200
0.320
0.192
0.115
0.115
0.058

Tax
Depreciation
(1) (2)
$ 400,000
640,000
384,000
230,000
230,000
116,000

$2,000,000

(4)

(5)

(6)

5-year
Tax
Straight-Line AmortiSoftware Amortization zation
Tax Basis
Rate
(4) (5)
$200,000
200,000
200,000
200,000
200,000
200,000

0.200
0.200
0.200
0.200
0.200
0.000

95,220

(7)
Total Tax
Amortization and
Depreciation
(3) + (6)

$ 40,000
40,000
40,000
40,000
40,000
0

$ 440,000
680,000
424,000
270,000
270,000
116,000

$200,000

$2,200,000

23-26

Chapter 23

P23-8 (Concluded)
(2)
Inflation
Adjusted
Periodic Net
After-Tax
Year
Cash Inflows
Needed
Balance
1
$355,320
$2,200,000
$1,844,680
2
586,498
1,844,680
1,258,182
3
595,476
1,258,182
662,706
4
640,560
662,706
22,146
5
780,039
22,146
0
Total payback in years........................................................

Payback
Years
Required
1.00
1.00
1.00
1.00
0.03
4.03

(3)
InflationAdjusted
Present
Periodic Net
Value
After-Tax
of $1
Year
Cash Inflows
@14%
0
$(2,200,000)
1.000
1
355,320
0.877
2
586,498
0.769
3
595,476
0.675
4
640,560
0.592
5
780,039
0.519
6
935,378*
0.456
Net present value of investment.......................... ......................

Present
Value
of Cash
Inflows
$(2,200,000)
311,616
451,017
401,946
379,212
404,840
426,532
$ 175,163

*$840,158 after-tax cash inflow for year 6 plus $95,220 after-tax salvage value at
the end of year 6.

Chapter 23

23-27

P23-9
Purchase alternative:

Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

(1)

(2)

(3)

(4)

Cash
Inflows

MACRS
Depreciation
Rate

Income
Tax
Depreciation*

$600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000

.143
.245
.175
.125
.089
.089
.089
.045
.000
.000
.000
.000
.000
.000
.000

$286,000
490,000
350,000
250,000
178,000
178,000
178,000
90,000
0
0
0
0
0
0
0

(5)

(6)

Increase
in Taxable
Income
(1) (3)

Income
Tax
Rate

Increase
in Income
Tax
(4) (5)

$314,000
110,000
250,000
350,000
422,000
422,000
422,000
510,000
600,000
600,000
600,000
600,000
600,000
600,000
600,000

.40
.40
.40
.40
.40
.40
.40
.40
.40
.40
.40
.40
.40
.40
.40

$125,600
44,000
100,000
140,000
168,800
168,800
168,800
204,000
240,000
240,000
240,000
240,000
240,000
240,000
240,000

(7)
Net
After-Tax
Cash
Inflows
(1) (6)
$ 474,400
556,000
500,000
460,000
431,200
431,200
431,200
396,000
360,000
360,000
360,000
360,000
360,000
360,000
360,000

After-tax cash inflow from salvage at end of economic life....................................................

$6,200,000
120,000 **

Total after-tax cash inflow from the purchase alternative .......................................................

Less initial cash outflow .............................................................................................................

$6,320,000
2,000,000

Total after-tax cash inflow over economic life of project ........................................................

$4,320,000

*The depreciation is determined by multiplying the depreciable basis of $2,000,000 by the MACRS
cost recovery percentages provided in Exhibit 22-4 of the text for seven-year property.
** The salvage received at the end of the economic life of the asset would be fully taxable because
the tax basis of the property would be zero. The after-tax cash inflow would be $120,000, i.e.,
($200,000 salvage value (1 .40 tax rate)).

23-28

Chapter 23

P23-9 (Concluded)

Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Net

Net
After-Tax
PV of $1
Cash Flow
@ 14%
$(2,000,000)
1.000
474,400
.877
556,000
.769
500,000
.675
460,000
.592
431,200
.519
431,200
.456
431,200
.400
396,000
.351
360,000
.308
360,000
.270
360,000
.237
360,000
.208
360,000
.182
360,000
.160
360,000
.140
present value .................................................

PV of
Cash Flow
$(2,000,000)
416,049
427,564
337,500
272,320
223,793
196,627
172,480
138,996
110,880
97,200
85,320
74,880
65,520
57,600
50,400
$ 727,129

Lease alternative:
Annual
Annual
Annual
Annual
Annual

Year
1-15

cash inflow before lease payment...................................

lease payment....................................................................
pretax cash inflow and increase in taxable income ......
increase in income tax expense ($280,000 40%) ........
after-tax cash inflow from lease alternative ...................

Cash
Inflow
$168,000

PV of
Annuity
$1 @ 14%
6.142

$600,000
320,000
$280,000
112,000
$168,000
PV of
Cash
Flows
$1,031,856

The lease alternative appears to be preferable because the net present value of
the estimated after-tax cash flows is greater than for the purchase alternative
($1,031,856 versus $727,129).

Chapter 23

23-29

P23-10
(1)
General-Purpose
SelfEquipment
Constructed
Lease Purchase Equipment
Recurring cash flows from operations:
Estimated sales volume in units........................
Unit contribution margin.....................................
Estimated total contribution margin..................

40,000
$ 1.55
$62,000

40,000
$ 1.55
$62,000

40,000
$ 1.90
$76,000

Less fixed costs:

Supervision ..........................................................
Property taxes and insurance ............................
Maintenance .........................................................
Total fixed cost ....................................................
Annual cash inflows before tax.................................

$16,000
0
0
$16,000
$46,000

$16,000
3,000
3,000
$22,000
$40,000

$17,000
5,000
2,000
$24,000
$52,000

Lease equipment alternative:

Annual cash inflow before tax.............................................
Annual lease payment..........................................................
Annual increase in taxable income ....................................
Annual increase in income tax ($6,000 40%)..................
Annual after-tax cash inflow................................................
PV of $1 received annually for 6 years @ 14%..................
Net present value of lease alternative ................................

$46,000
40,000
$ 6,000
2,400
$ 3,600
3.889
$14,000

23-30

Chapter 23

P23-10 (Continued)
Purchase equipment alternative:
(1)

(2)

(3)

Year

Pretax
Cash
Inflows

Income
Tax
Depreciation*

1
2
3
4
5
6

$40,000
40,000
40,000
40,000
40,000
80,000**

$25,000
40,000
24,000
14,375
14,375
7,250

Taxable
Income
(1) (2)

(4)
Income
Tax
at 40%
Tax Rate
(3) 40%

(5)
Net
After-Tax
Cash
Inflows
(1) (4)

(6)

PV of $1
@ 14%

(7)
PV of Net
After-Tax
Cash
Inflows
(5) (6)

$15,000
0
16,000
25,625
25,625
72,750

$ 6,000
0
6,400
10,250
10,250
29,100

$34,000
40,000
33,600
29,750
29,750
50,900

.877
.769
.675
.592
.519
.456

$ 29,818
30,760
22,680
17,612
15,440
23,210

Present value of net cash inflows ...........................................................................

Less initial cash outflow ..........................................................................................

$139,520**
125,000

Net present value of purchase alternative .............................................................

$ 14,520

*Tax depreciation is determined by multiplying the depreciable basis of the equipment under the
purchase alternative ($125,000) by the MACRS depreciation rates provided in Exhibit 22-4 of the
text.
**Includes salvage value of $40,000, all of which would be taxable, since the equipment would be
fully depreciated for income tax purposes at the end of the sixth year.The total after-tax cash flow
from operations of $50,900 shown in column (5) is composed of after-tax cash inflow from operations of $26,900 ($40,000 (($40,000 $7,250) .40 tax rate)) and the after-tax cash flow from
salvage of $24,000 ($40,000 (1 .40 tax rate)).

Chapter 23

23-31

P23-10 (Continued)
Self-constructed equipment alternative:
(1)

(2)

(3)

Year

Pretax
Cash
Inflows

Income
Tax
Depreclation*

1
2
3
4
5
6

$52,000
52,000
52,000
52,000
52,000
82,000**

$36,000
57,600
34,560
20,700
20,700
10,440

Taxable
Income
(1) (2)

(4)
Income
Tax
at 40%
Tax Rate
(3) 40%

(5)
Net
After-Tax
Cash
Inflows
(1) (4)

(6)

PV of $1
@ 14%

$16,000
(5,600)
17,440
31,300
31,300
71,560

$ 6,400
(2,240)
6,976
12,520
12,520
28,624

$45,600
54,240
45,024
39,480
39,480
53,376

.877
.769
.675
.592
.519
.456

(7)
PV of Net
After-Tax
Cash
Inflows
(5) (6)
$ 39,991
41,711
30,391
23,372
20,490
24,339

Present value of net cash inflows ..........................................................................

Less initial cash outflow ..........................................................................................

$180,294
165,000***

Net present value of purchase alternative .............................................................

$ 15,294

* Tax depreciation is determined by multiplying the depreciable basis of the equipment under the
self-construction alternative ($180,000, which is the full construction cost including allocated
fixed cost) by the MACRS depreciation rates provided in Exhibit 22-4 of the text.
**Includes salvage value of $30,000, all of which would be taxable, since the equipment would be
fully depreciated for income tax purposes at the end of the sixth year.The total after-tax cash flow
from operations of $53,376 shown in column (5) is composed of after-tax cash inflow from operations of $35,376 ($52,000 (($52,000 $10,440) .40 tax rate)) and the after-tax cash flow from
salvage of $18,000 ($30,000 (1 .40 tax rate)).
***Because Egelston Corporation is operating at normal capacity and the construction of the new
equipment will not interfere with regular activities, the company should not incur any additional
fixed factory overhead. Therefore, the $15,000 of fixed factory overhead is not included in the differential cost of the self-constructed asset. The initial cash outlay would be $180,000 full cost
less $15,000 of allocated fixed factory overhead, or $165,000.

23-32

Chapter 23

P23-10 (Concluded)
(2)

Egelston Corporation should consider any proposal that is expected to have an

earnings rate in excess of the firms cost of capital. If a proposal has a positive
net present value, that proposals expected earnings will yield a rate of return that
exceeds the firms cost of capital. In this case, the purchase of general-purpose
equipment, the construction of special-purpose equipment, and the lease of general-purpose equipment are all acceptable to Egelston Corporation, because the
net present value of all three proposals is positive.
Egelston Corporation should attempt to maximize the earnings that can be
obtained from the funds available for capital investments. When comparing a set
of mutually exclusive alternatives, the alternative with the largest net present
value will result in a maximization of stockholder wealth. Accordingly, construction of special-purpose equipment appears to be the most attractive alternative.
However, the net present value should be related to any required investment by
calculating a net present value index as follows:
Construction of special-purpose equipment:
Net present value
=
Required investment

$15,294 = .0927
$165,000

Purchase of special-purpose equipment:

Net present value
=
Required investment

$14,520
$125,000

= .1162

Purchase of general-purpose equipment promises a larger net present value

index and would be preferable, provided that the investment difference of
$40,000 ($165,000 $125,000) can be used to earn a net present value greater
than $774 ($15,294 $14,520).

Chapter 23

23-33

CASES
C23-1
(1)

(a) The payback method measures the number of years required for the
after-tax cash inflows to fully recover the initial cash investment in a project.
The payback method emphasizes an organizations financial liquidity and
the riskiness of the capital project in terms of investment recovery. Since
long-term forecasts contain more uncertainty than short-term forecasts (i.e.,
it is easier to predict what will happen next year than what will happen 10
years from now), the least risky projects will have the shortest payback
period.
(b) The net present value method recognizes the time value of money by discounting the after-tax cash flows for a project over its life to time zero using
the firms weighted average cost of capital. The net present value is the difference between the present value of the after-tax cash inflows, measured over
the life of the capital project, and the cash outflow required to undertake the
capital project. Projects that have a positive net present value are acceptable,
while those that have a negative net present value are unacceptable.
(c) The internal rate of return method (also called the discounted cash flow rate
of return method) incorporates the time value of money by determining the
compound interest rate for a capital project that would result in a net present value of zero. A proposal would be acceptable if the internal rate of
return exceeds the weighted average cost of capital, and unacceptable if it
is less.

(2)

In order to maximize the value of the company, Caledonia Division should use
the net present value method or the internal rate of return method to decide
which capital projects should be included in the capital budget submitted to
Quible Industries. Both of these methods would identify Projects A, B, D, E, and
F as acceptable (each has a positive net present value and an internal rate of
return in excess of the companys hurdle rate), and Project C as unacceptable
(the net present value is negative and the internal rate of return is less than the
companys hurdle rate). However, Projects A and D are mutually exclusive (meaning that ultimately only one of the two can be pursued). The selection between
the two depends upon the criteria used to rank the projects, i.e., the capital
expenditure evaluation method employed in the selection process. If the net
present value method is used, Caledonia would select Project D because it has
a higher net present value than Project A ($74,374 for D compared to $69,683 for
A). On the other hand, if the internal rate of return method is used, Caledonia
would select Project A because it has a higher internal rate of return than Project
D (35% for A compared to 22% for D).

23-34

Chapter 23

C23-1 (Concluded)
(3)

In order to maximize the value of the company in this capital rationing situation,
the net present value should be used to select the projects to be included in the
capital budget because the cash inflows are assumed to be reinvested at the
hurdle rate (the company has a demonstrated earning rate equal to its weighted
average cost of capital). The internal rate of return should not be used, because
it violates the reinvestment rate assumption and may be unreliable as a basis for
maximizing the value of the company in a capital rationing situation. Using the
net present value method, the most profitable combination of projects within the
$450,000 budget constraint would be to include Projects A, B, and F because this
combination yields the greatest total net present value (net present value of
$162,929 for an initial investment of $436,000). (Note that the combination of A,
D, and F is not possible because A and D are mutually exclusive projects, and
that the combination of B, D, and F is not possible because it would require a
combined investment in excess of $450,000.)

C23-2
(1)

The 18.2% rate of return on the investment differs from the 24% internal rate of
return because the methods used to measure the returns are different.
The return on investment (18.2%) calculation is based on accrual accounting
concepts. If the reduced operating expensesless depreciationremain constant as planned, the numerator in the ROI fraction will not change over the life
of the investment. The denominator in the fraction, the investment base,
decreases each year by the amount of the annual depreciation. Consequently,
the rate of return calculated will increase each year over the life of the investment.
The internal rate of return calculation (24%) is based on discounted cash flow
concepts. The cash flows expected to be received over the life of the investment,
discounted to the acquisition date at 24%, exactly equaled the initial cost of the
machine. This measure of return on investment provides a percentage that is
constant for each year of life of the investment. This rate can be computed for
each years actual operating results if the annual savings in operating expenses
are constant and the new equipment is depreciated using the effective interest
method based on an interest rate of 24%. The method would be essentially the
same as that employed in amortizing leaseholds and bonds. The depreciation
charge each year would have to be such that the numerator and the denominator of the ROI computation would change at the same rate in order to keep the
annual return on investment ratio constant.

Chapter 23

23-35

C23-2 (Concluded)
(2)

Recap Corporation can restructure the data from the cash flow analysis to make
it consistent with the accounting reports (which contain straight-line depreciation) received by the department manager. Once the investment is accepted on
the basis of its internal rate of return, the data can be converted into the format
consistent with the accounting basis used for reporting. Annual contribution
from the new investment would be calculated by subtracting the straight-line
depreciation from the net cash operating savings. The accounting book value for
each of the years of the investment life would also be calculated. The annual contribution would be divided by the investment base (book value) for each year to
obtain the rates of return. This would then present the manager with the different rates of return for each of the years of the investments life. Thus, the rates
would be more comparable with the actual return on investment rates experienced each year.
Alternatively, rather than computing an annual rate of return, it may be more
expedient to compare actual net cash operating savings each year with those
forecast in the capital expenditure analysis. If actual periodic savings equal
those forecast, the internal rate of return would be equal to the 24% budgeted.