Capital Budgeting

CHAPTER 15
CAPITAL BUDGETING
QUESTIONS
1. Capital assets are the long-lived assets acquired by firms. Capital assets provide
the essential production and distributional capabilities required by all
organizations.
2. Cash flows are the focus of capital budgeting investments just as cash flows are the
focus of any investment. Accounting income ultimately becomes cash flow but is
reported based on accruals and other accounting assumptions and conventions.
These accounting practices and assumptions detract from the purity of cash flows
and, therefore, are not used in capital budgeting.
3. Time lines provide clear visual models of the expected cash inflows and outflows
for each point in time for a project. They provide an efficient and effective means
to help organize the information needed to perform capital budgeting analyses.
4. The payback method measures the time expected for the firm to recover its
investment. The method ignores the receipts expected to occur after the
investment is recovered and ignores the time value of money.
5. Return of capital means the investor is receiving the principal that was originally
invested. Return on capital means the investor is receiving an am ount earned on
the investment.
6. The NPV of a project is the present value of all cash inflows less the present value
of all cash outflows associated with a project. If the NPV is zero, it is acceptable
because, in that case, the project will exactly earn the required rate of return. Also,
when NPV equals zero, the projects internal rate of return equals the cost of capital.
7. It is highly unlikely that the estimated NPV will exactly equal the actual NPV
achieved because of the number of estimates necessary in the original
computation. These estimates include the project life, discount rate chosen, and
timing and amounts of cash inflows and outflows. The original investment may
also include an estimate of the amount of working capital needed at the
beginning of the project life.
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website, in whole or in part.
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Chapter 15
8. The NPV method subtracts the initial investment from the discounted net cash
inflows to arrive at the net present value. The profitability index (PI) is calculated
by dividing the discounted cash inflows by the initial investment. Thus, each
computation uses the same set of amounts in different ways. By measuring the
expected dollars of discounted cash inflows per dollar of project investment, PI
attempts to measure the planned efficiency of the use of the money (i.e., output
to input). A PI equal to or greater than 1 is equivalent to a NPV equal to or
greater than zero and indicates that the investment will provide an acceptable
return on capital.
9. The IRR is the rate that would cause the NPV of a project to equal zero. A project
is considered potentially successful (all other factors being acceptable) if the
calculated IRR equals or exceeds the company's cost of capital.
10. The amount of depreciation for a year is one factor that helps determine the
amount of cash outflow for income taxes. Therefore, although depreciation is not a cash flow
item itself, it does affect the size of another item (income taxes) that is a cash flow.
11. The four questions are:
1. Is the activity worthy of an investment?
2. Which assets can be used for the activity?
3. Of the assets available for each activity, which is the best investment?
4. Of the best investments for all worthwhile activities, in which ones should the
company invest?
12. Risk is defined as the likely variability of the future returns of an asset. Aspects of
a project for which risk is involved are:
Life of the asset
Amount of cash flows
Timing of cash flows
Salvage value of the asset
Tax rates
When risk is considered higher in capital budgeting analysis, the NPV of a project
is lowered.
13. Sensitivity analysis is used to determine the limits of value for input variables
(e.g., discount rate, cash flows, asset life, etc.) beyond which the project's
outcome will be significantly affected. This process gives the decision maker an
indication of how much room there is for error in estimates for input variables and
which input variables need special attention.
14. Post-investment audits are performed to determine whether the realized return
matches the expected return on a project. Post-investment audits are typically
performed at or near the end of a projects life.
Chapter 15
15. The time value of money refers to the concept that money has time-based
earnings power. Money can be loaned or invested to earn a rate of return.
Present value is always less than future value because of the time value of
money. A future value must be discounted to determine its equivalent (but
smaller) present value. The discounting process strips away the imputed rate of
return in future values, thus present values are less than future values.
16. ARR = Average annual profits Average investment
Unlike the rate used to discount cash flows or to compare to the cost of capital
rate, the ARR is not a discount rate to apply to cash flows. It is measured from
accrual-based accounting information and is not intended to be associated with
cash flows.
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Chapter 15
EXERCISES
17. Investors are ultimately most interested in cash flows. Investors cannot spend
accounting earnings; they can only spend the cash that is ultimately derived from
their investment in the firm. Investors are interested in accounting earnings
because they reveal information about present and future cash flows that is not
revealed in examining only cash flows. Hence, accounting earnings are only
useful to investors if they help inform the investors about cash flows.
18. Cash flows
Period:
0
-2,000,000 600,000
2
600,000
Accounting earnings
Period:
0
1
Expense savings 600,000
Depreciation
-400,000
3
600,000
2
600,000
4
600,000
5
600,000
3
4
5
600,000
600,000
600,000
-400,000 -400,000
-400,000
-400,000
19. No solution provided.

20. The main point made in the report should be that stock prices are expected
future cash flows of the firm discounted at an appropriate risk-adjusted disc ount
rate. The risk-adjusted discount rate is a function of both the riskiness of the
specific security and the prevailing market rates of interest. As the prevailing
market interest rates change, the value of securities change alsoespecially
those that have distant future cash flows that comprise a significant portion of the
value of the security, e.g., growth stocks.
21. a. Payback = $1,500,000 $300,000 per year = 5.00 years
b. Year
Amount Cumulative Amount
1 $150,000 $ 150,000
2 150,000
300,000
3 150,000
450,000
4 150,000 600,000
5 150,000 750,000
6 200,000 950,000
7 200,000 1,150,000
8 200,000
1,350,000
9 200,000
1,550,000
10
200,000
1,750,000
The payback is 8 years plus (1,500,000 1,350,000)/200,000 = 8.75 years.
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Chapter 15
22. a. Year
Amount
1 $70,000 $ 70,000
2 78,000 148,000
3 72,000 220,000
4 56,000 276,000
5 50,000 326,000
6 48,000 374,000
7 44,000 418,000
Cumulative Amount
Payback = 4 years + ($320,000 - $276,000)/$50,000 = 4.88 years

Based on the payback criterion, Eastgate should not invest in the proposed
product line.
b. Yes. Eastgate should also use a discounted cash flow technique for two
reasons: (1) to take into account the time value of money and (2) to consider
those cash flows that occur after the payback period.
23. Point in Time Cash Flows PV Factor
Present Value
0
$(1,800,000) 1.0000
$(1,800,000)
1
280,000
0.8929
250,012
2
280,000
0.7972
223,216
3
340,000
0.7118
242,012
4
340,000
0.6355
216,070
5
340,000
0.5674
192,916
6
288,800
0.5066
146,306
7
288,800
0.4524
130,653
8
288,800
0.4039
116,646
9
260,000
0.3606
93,756
10
260,000
0.3220
83,720
NPV
$ (104,693)
Based on the NPV, this is an unacceptable investment.
24. a. The contribution margin of each part is $1 ($7.50 - $6.50)
Contribution margin per year = $1 x 100,000 = $100,000
0
1-8
NPV
Point in Time Cash Flows PV Factor

Present Value
$ (500,000)
1.0000
$ (500,000)
1-8
(20,000)
5.5348
(110,696)
100,000
5.5348
553,480
$ (57,216)
b. Based on the NPV, this is not an acceptable investment.
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Chapter 15
c. Other considerations would include whether refusing to produce this part for
the customer would cause a loss of other business from the customer. The
company should also consider going back to the customer and asking for a
higher price that would cause the project to have a positive NPV.
25. PI = PV of cash inflows PV of cash outflows
= ($6,000 + $120,000) $120,000 = 1.05
26. a. PV of inflows: $584,011 ($91,000 x 6.4177)
PV of investment: $600,000
PI = $584,011 $600,000 = 0.97
b. Nashville Tours should not add the bus route because the PI is less
than 1.00.
c. To be acceptable, a project must generate a PI of at least 1; a PI greater
than 1 equates to an NPV > 0.
27. a. PV = discount factor x annual cash inflow
$700,000 = discount factor x $144,000
Discount factor = $700,000 $144,000 = 4.8611
The IRR is 13% rounded to the nearest whole percent.
b. Yes. The IRR on this proposal is greater than the firm's hurdle rate of 7%.
c. $700,000 = 5.9713 x Annual cash flow
Annual cash flow = $700,000 5.9713
Annual cash flow = $117,227
28. a. PV = discount factor x annual cash inflow
$900,000 = discount factor x $150,000
Discount factor = $900,000 $150,000 = 6.0000
The IRR is 10.5% rounded to the nearest half percent.
The project is acceptable because the IRR exceeds the discount rate.
b. The main qualitative factors would be the effect of the technology on the
perceived quality of the food that is processed by the new machinery. An
additional consideration would be the effect of the technology on employees,
particularly if the investment would cause layoffs.
29. Investment cost = $125,000 discount factor for 14%, 7 years
= $125,000 4.2883 = $536,038
NPV = $125,000 discount factor (10%, 7 years) - $536,038
= ($125,000 4.8684 - $536,038 = $72,512
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Chapter 15
30. a. Straight-line method

Annual depreciation = $1,000,000 8 years = $125,000 per year
Tax benefit = $125,000 x 0.30 = $37,500
PV = $37,500 x 5.7466 = $215,498
b. Accelerated method
$1,000,000 x 0.30 x 0.40 x .9259 = $111,108
$600,000 x 0.30 x 0.40 x .8573 =
61,726
$360,000 x 0.30 x 0.40 x .7938 =
34,292
$216,000 x 0.30 x 0.40 x .7350 =
19,051
* x 0.30 x .6806 =
$129,600
26,462
Total
$252,639
*
In the final year, the remaining undepreciated cost is expensed.
c. The depreciation benefit computed in part (b) exceeds that computed in par t
(a) solely because of the time value of money. The depreciation method in
part (b) allows for faster recapture of the cost; therefore, there is less
discounting of the future cash flows.
31. a. SLD = $18,000,000 8 years = $2,250,000 per year
Before-tax CF $3,100,000
Less depreciation 2,250,000
Before-tax NI
$ 850,000
Less tax (30%)
255,000
NI $ 595,000
Add deprec iation 2,250,000
After-tax CF $2,845,000
NPV
Point in Time Cash Flows

PV Factor
Present Value
0
$(18,000,000) 1.0000
$(18,000,000)
1-8
2,845,000
6.4632
18,387,804
$ 387,804
The project is acceptable because the NPV is positive.

b.
Years 1 and 2
Before-tax CF $ 3,100,000 $3,100,000
Less Depreciation 4,140,000 1,620,000
Before-tax NI (1,040,000)
1,480,000
Tax (tax benefit)
(312,000)
444,000
After-tax NI
(728,000) 1,036,000
Add Depreciation 4,140,000 1,620,000
After-tax CF $ 3,412,000 $2,656,000
Years 3-8
456
0
1-2
3-8
NPV
Chapter 15
Point in Time
Cash Flows
PV Factor
$(18,000,000) 1.0000
$(18,000,000)
3,412,000
1.8594
6,344,273
2,656,000
4.6038
12,227,693
$ 571,966
Present Value
The project is acceptable. Note, because of the more rapid depreciation

used in part b. relative to part a., the NPV is more positive in part b. than in
part a.
c.
Before-tax CF $3,100,000
Less depreciation 2,250,000
Before-tax NI
$ 850,000
Less tax (40%)
340,000
NI $ 510,000
Add deprec iation 2,250,000
After-tax CF $2,760,000
NPV
Point in Time Cash Flows

PV Factor
Present Value
0
$(18,000,000) 1.0000
$(18,000,000)
1-8
2,760,000
6.4632
17,838,432
$ (161,568)
The project is unacceptable because the NPV is negative

Years 1 and 2 Years 3-8
Before-tax CF $ 3,100,000 $3,100,000
Less Depreciation 4,140,000 1,620,000
Before-tax NI (1,040,000)
1,480,000
Tax (tax benefit)
(416,000)
592,000
After-tax NI
(624,000)
888,000
Add Depreciation 4,140,000 1,620,000
After-tax CF $ 3,516,000 $2,508,000
0
1-2
3-8
NPV
Point in Time
Cash Flows
PV Factor
$(18,000,000) 1.0000
$(18,000,000)
3,516,000
1.8594
6,537,650
2,508,000
4.6038
11,546,330
$
83,980
Present Value
The project is acceptable.

32. a. Tax: $95,000 - $18,000 = $77,000
Financial accounting: $95,000 - $35,000 = $60,000
b. CFAT = Market value now minus taxes
= $37,000 - (($37,000 - $18,000) x .30) = $31,300
c. CFAT = $9,000 - (($9,000 - $18,000) x .30) = $11,700
Chapter 15
33. a. payback
b. NPV, PI
c. IRR
d. payback, NPV, PI, IRR
e. all methods
f. payback
g. ARR
34. a. payback, NPV, PI, IRR
b. payback
c. ARR
d. payback, ARR
e. payback, NPV, PI, IRR
f. all methods
g. IRR
h. payback, IRR, ARR, PI
35. a.
Project Name NPV
PI
IRR
Film studios $3,578,910 1.18
13.03%
Cameras & equipment 1,067,920 1.33
18.62
Land improvement 2,250,628 1.45
19.69
Motion picture #1 1,040,276 1.06
12.26
14.09
21.32
Corporate aircraft
518,916 1.22
18.15
2.
3.
4.
5.
6.
7.
b. Ranking according to:

NPV
PI IRR
1. Film Studios Land improvement MP #3
MP #3
MP#3
Land Improvement
Land Improvement Camera & Equip. Camera & Equip.
Camera & Equip. Corp. Aircraft Corp. Aircraft
MP #1
Film Studio
MP #2
MP #2 MP #2
Film Studios
Corp. Aircraft MP #1
MP #1
c. Suggested purchases:
NPV
1. MP #3 @ $8,000,000
$3,197,320
2. Land improvement @ $5,000,000
2,250,628
3. Cam. & Equip. @ $3,200,000
1,067,920
4. Corp. Aircraft @ $2,400,000
518,916
Total NPV $7,034,784
36. a. Cash flow x annuity factor = $80,000
Cash flow x 3.7908 = $80,000
Cash flow = $21,104
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Chapter 15
b. $80,000 $21,104 = 3.79 years

37. a. NPV = ($28,000 4.8684) - $100,000 = $36,315
b. annuity factor $28,000 = $100,000
annuity factor = $100,000 $28,000 = 3.5714
This factor corresponds most closely to 20%
38. PV = FV discount factor
$60,000 = FV .7473
FV = $60,000 .7473 = $80,289
39. Cost = $8,000 + PV($600 annuity) = $8,000 + ($600 x 37.9740
*
discount factor for 48 months, 1%
40. a. PV = future value x discount factor

= $50,000 x .6302
= $31,510 should be invested to achieve the goal
b. PV = future value x discount factor
= $400,000 x .3769
= $150,760 would be equivalent today
c. PV = future value x discount factor
= $60,000 x .2146
= $12,876
d. Present value = annuity x annuity discount factor
= $200,000 x 3.9927
= $798,540
e. Year 1 receipt: $ 50,000 x .9346 = $ 46,730
Year 2 receipt: $ 55,000 x .8734 = 48,037
Year 3 receipt: $ 60,000 x .8163 = 48,978
Year 4 receipt: $100,000 x .7629 = 76,290
Year 5 receipt: $100,000 x .7130 = 71,300
Year 6 receipt: $100,000 x .6663 = 66,630
Year 7 receipt: $100,000 x .6228 = 62,280
Year 8 receipt: $100,000 x .5820 = 58,200
Year 9 receipt: $ 70,000 x .5439 = 38,073
Year 10 receipt: $ 45,000 x .5084 = 22,878
Present value
$539,396
f. No. Using any discount rate above 0, the present value of the future annual
cash flows is well below $1,000,000.
) = $30,784
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Chapter 15
41. a. Change in net income = $20,000,000 - ($72,000,000 5) = $5,600,000

ARR = $5,600,000 ($72,000,000 2) = 15.56%
Payback = $72,000,000 $20,000,000 per year = 3.6 years
b. No. Although the dredge meets the payback criterion, it fails to meet the ARR
criterion of 18%.
42. a. Annual cash receipts
Cash expenses
(3,000)
Net cash flow before taxes
$12,000
Depreciation
(6,667)
Income before tax
$ 5,333
Taxes
(1,600)
Net income
$ 3,733
Depreciation
6,667
Annual after-tax cash flow $10,400
$ 15,000
b. Payback = $40,000 $10,400 per year = 3.85 years

c. ARR = $3,733 ($40,000 2) = 18.67%
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Chapter 15
PROBLEMS
43. a. A lease is often found appealing by consumers because it results in a lower
monthly payment in many instances than the monthly payment that is
required to purchase a car. This allows the consumer either to enjoy a lower
monthly payment or, for the same monthly payment required to amortize the
cost of one vehicle, pay a similar monthly amount for a more expensive car.
b. No. A consumer should be provided with all necessary information to make
a fair comparison between the lease and purchase alternative.
c. As an accountant, you could provide a financial comparison of the lease and
purchase alternatives. Using a discounted cash flow approach, you could
compare the present value of purchasing the vehicle to the present value of
leasing the vehicle.
44. a. Although the 12% hurdle rate may be appropriate for most projects, it may
be inappropriate to insist that a project such as a pollution abatement
project be required to meet any financial hurdle rate.
b. In the future, the company could face not only significant fines from
government regulators, but also financial claims filed by persons harmed
by the arsenic.
c. Klammer should justify the investment based both on the potential future
financial claims and that it is the socially and ethically correct action for the
company to take.
45. a. ($000s omitted)
t0 t1
t2
t3
t4
t5
t6
t7
t8
Investment -190
New CM
60
60
60
60 60
60
60
60
Oper. costs
0 -20 -27 -27 -27 -30 -30
-30 -33
Cash flow -190 40 33 33 33 30
30 30 27
1
2
3
4
5
6
b. Year Cash Flow Cumulative Cash Flow

$40,000 $ 40,000
33,000
73,000
33,000
106,000
33,000
139,000
30,000
169,000
30,000
199,000
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Chapter 15
Payback = 5 + (($190,000 - $169,000) $30,000) = 5.7 years

c. Time
Cash Flow PV Factor for 8%
0 $(190,000) 1.0000 $(190,000)
1
40,000 .9259
37,036
2
33,000 .8573
28,291
3
33,000 .7938
26,195
4
33,000 .7350
24,255
5
30,000 .6806
20,418
6
30,000 .6302
18,906
7
30,000 .5835
17,505
8
27,000 .5403
14,588
NPV $ (2,806)
46. a. Time:
t0
t1
t2
t3
t4
Present Value
t5
t6
t7
Amount: ($41,000) $5,900 $8,100 $8,300 $8,000 $8,000 $8,300 $9,200
b. Year
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$5,900
8,100
8,300
8,000
8,000
8,300
Cash Flow Cumulative

$ 5,900
14,000
22,300
30,300
38,300
46,600
Payback = 5 years + (($41,000 - $38,300) $8,300) = 5.33 years

c. Cash Flow
Description
Time
Purchase the truck
Cost savings
t1
Cost savings
t2
Cost savings
t3
Cost savings
t4
Cost savings
t5
Cost savings
t6
Cost savings
t7
NPV
Amount
Factor
t0
$(41,000)
5,900
.9259
8,100
.8573
8,300
.7938
8,000
.7350
8,000
.6806
8,300
.6302
9,200
.5835
$ (80)
Discount
Value
1.0000
5,463
6,944
6,589
5,880
5,445
5,231
5,368
Present
$(41,000)
47. a. Year
Cash Flow PV Factor
PV
0 $(5,000,000) 1.0000 $(5,000,000)
1- 7
838,000 5.5824
4,678,051
7
400,000
.6651
266,040
NPV
$
(55,909)
b. No, the NPV is negative; therefore this is an unacceptable project.
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Chapter 15
c. PI = ($4,678,051 + $266,040) $5,000,000 = 0.99

d. PV of annual cash flows = $5,000,000 - $266,040
PV of annual cash flows = $4,733,960
PV of annual Cash flows = Annual cash flow x 5.5824
$4,733,960 = Annual cash flow x 5.5824
Annual cash flow = $4,733,960 5.5824 = $848,015
Minimum labor savings = $848,015 + operating costs
= $848,015 + $112,000
= $960,015
e. The company should consider the quality of the work performed by the
machine versus the quality of the work performed by the individuals; the
reliability of the manual process versus the reliability of the mechanical
process; and perhaps most importantly, the effect on worker morale and the
ethical considerations in displacing 14 workers.
48. a. Payback period = $140,000 ($47,500 - $8,500) = 3.59 years
The project does not meet the payback criterion
.
b. Discount factor = Investment annual cash flow
= $140,000 $39,000 = 3.5897
Discount factor of 3.5897 indicates IRR 4 %
This is an unacceptable IRR.
c. Foster should consider two main factors. First, the effect of the computer
system on the accuracy of tax returns and the quality of service delivered to
clients. Second, Foster should consider the effect of firing one employee on
both the dismissed employee and the remaining employees.
49. a. The incremental cost of the new machine: $580,000 - $12,000 = $568,000
Cash Flow
Discount
Description
Time
Incremental cost
t0
Cost savings
t1 - t8
NPV
Present
Amount
$(568,000)
120,000
Factor
Value
1.0000 $ (568,000)
5.3349
640,188
$ 72,188
PI = $640,188 $568,000 = 1.13

Yes, the machine should be purchased because the NPV > 0 and the PI > 1.
b. Payback = $568,000 120,000 per year = 4.73 years
c. Net investment annual annuity = discount factor of IRR
$568,000 120,000 = 4.7333
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Discount factor of 4.7333 is between 13.0 and 13.5%; therefore, to the

nearest whole percent, the IRR is 13%.
50. a. Computation of net annual cash flow:
Increase in revenues
$ 46,000
Increase in cash expenses
(21,000)
Increase in pretax cash flow
25,000
Less Depreciation
(9,750)
Income before tax
15,250
Income taxes (30 percent)
(4,575)
Net income
10,675
Add Depreciation
9,750
After-tax cash flow
$ 20,425
Description
Time
Initial cost t
Annual cash flow t
NPV
Cash Flow Discount

Amount
Factor
Value
$(195,000)
1.0000
$(195,000)
0
- t20 20,425 9.1286
186,452
1
$ (8,548)
Present
b. This is not an acceptable investment because the NPV is not close to the
cutoff value of $0.
c. Minimum annual after tax cash flow x discount factor = $195,000
Minimum annual after tax cash flow x 9.1286 = $195,000
Minimum annual after tax cash flow = $21,361
$21,361 = (minimum cash revenues - $21,000 - $9,750)(1 tax rate) + $9,750
$11,611 = (minimum cash revenues - $21,000 - $9,750)(1- .30)
$16,587 = minimum cash revenues - $30,750
Minimum cash revenues = $47,337
Proof: Computation of net annual cash flow:
Increase in revenues
$ 47,337
Increase in cash expenses
(21,000)
Increase in pretax cash flow
$ 26,337
Less Depreciation
(9,750)
Income before tax
$ 16,587
Income taxes (30 percent)
(4,976)
Net income
$ 11,611
Add Depreciation
9,750
After-tax cash flow
$
21,361
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Chapter 15
51. a. Cash flow after tax (CFAT):

Year
Pretax CF Depreciation
Tax
CFAT
1
$104,000
$ 64,000
$14,000 $ 90,000
2
118,000
102,400
5,460
112,540
3
118,000
60,800
20,020
97,980
4
102,000
48,000
18,900
83,100
5
86,000
44,800
14,420
71,580
Timeline:
t0
t1
t2
t3
t4
$(320,000) $90,000 $112,540 $97,980 $83,100 $71,580
t5
b. Year Net Cash Flow Cumulative Cash Flow

$ 90,000
$ 90,000
112,540
202,540
97,980
300,520
83,100 383,620
1
2
3
4
Payback = 3 years + (($320,000 300,520) $83,100) = 3.23 years.

Time
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
NPV
Net present value:

Amount Discount Factor Present Value
$(320,000) 1.0000
$(320,000)
90,000
.9259
83,331
112,540
.8573
96,481
97,980
.7938
77,777
83,100
.7350
61,079
71,580
.6806
48,717
$ 47,385
Profitability index = ($320,000 + $47,385) $320,000 = 1.15
IRR is 14%.
52. a. Maple Commercial Plaza:

t
t
- t10 t
0
1
$(800,000)
$210,000
$400,000
High Tower:
t
$(3,400,000)
t
0
$830,000
- t10 t
1
$1,500,000
10
10
465
Chapter 15
b. Maple Commercial Plaza:

Calculation of annual cash flow:
Pretax cost savings
$210,000
Depreciation ($800,000 25)
(32,000)
Pretax income
178,000
Taxes (40 percent)
(71,200)
Aftertax income
106,800
Depreciation
32,000
Aftertax cash flow
$138,800
t
$(800,000)
*
t
0
$138,800
- t10 t
1
$432,000
10
Includes $32,000 from tax loss on sale (0.40
($400,000 - $480,000))
High Tower:
Calculation of annual cash flow:
Pretax cost savings
$ 830,000
Depreciation ($3,400,000 25)
(136,000)
Pretax income
694,000
Taxes
(277,600)
Aftertax income
416,400
Depreciation
136,000
Aftertax cash flow
$ 552,400
t
$(3,400,000)
*
t
0
$552,400
- t10 t
1
$1,716,000
Includes $216,000 from tax loss on sale (0.40
10
*
($1,500,000 - $2,040,000))
c. After-tax NPV, Maple Commercial Plaza:

Amount Discount Factor
Present Value
Year 0 $(800,000) 1.0000
$(800,000)
Year 1-10 138,800
5.8892
817,421
Year 10
432,000
.3522
152,150
NPV
$ 169,571
After-tax NPV, Hightower:
Amount Discount Factor Present Value
Year 0 $(3,400,000) 1.0000
$(3,400,000)
Year 1-10
552,400 5.8892
3,253,194
Year 10
1,716,000
.3522
604,375
NPV
$ 457,569
Based on the NPV criterion, Hightower is the preferred investment.
466
Chapter 15
d. After-tax NPV, Hightower:

Amount Discount factor
Present Value
Year 0 $(3,400,000) 1.0000
$(3,400,000)
Year 1-10
180,400 5.8892
1,062,412
* 4.1925
Year 1-10
372,000
Year 10
1,716,000
.3522
604,375
NPV
$ (173,603)
*
1,559,610
Rental por tion of cash flow = $620,000

(1 - tax rate)
= $620,000 0.60
= $372,000
In this circumstance, Maple Commercial Plaza is the preferred investment.

53. a. Depreciation per year = $1,500,000 14 = $107,143
Before tax cash flows = [300 x 0.80 x ($70 - $20) x 50] - $250,000
= $350,000 per year
Before-tax CF $350,000
Less Depreciation (107,143)
Income before tax 242,857
Less tax (25%) (60,714)
Net income 182,143
Add Depreciation 107,143
After-tax cash flow $289,286
PV of 14 yr. annuity of $289,286 @ 10% $2,131,083
Less cost
NPV
(1,500,000)
$ 631,083
b. Discount factor = $1,500,000 $289,286 = 5.1852

Discount factor of 5.1852 corresponds to 17%.
c. Cash flow x discount factor = $1,500,000
Cash flow x (7.3667) = $1,500,000
Cash flow = $203,619
d. $1,500,000 $289,286 = 5.1852
5.1852 is the discount factor for 10% and falls between the 10% discount
factors corresponding to 7 and 8 years.
54. a. Incremental annual after-tax cash flows:
Purchase
Purchase of new equipment $(300,000)
One time production expense net of tax ($80,000 x .6) (48,000)
Sale of old equipment net of tax ($5,000 x .6)
3,000
Total initial cash outflow $(345,000)
Year 0
467
Chapter 15
Annual Operations
Year 1
Year 2
Year 3
Year 4
Cash operating
savings
$ 90,000 $150,000 $150,000 $150,000
Less tax effect (40%) (36,000)
(60,000)
(60,000) (60,000)
Cash savings after-tax
54,000
90,000
90,000
90,000
Depr. tax shield
(see sched. below)
48,000
36,000
24,000
12,000
After-tax operating
cash flows
$102,000 $126,000 $114,000 $ 102,000
1
2
3
4
4/10
3/10
2/10
1/10
Depreciation Schedule
Depreciable Base: $300,000
Life: Four-Year Limit
Method: Sum-of-the-Years'-Digits
Year
Rate
Depreciation
Depr. Shield
$120,000 $48,000
90,000 36,000
60,000
24,000
30,000 12,000
b. The company should reject the proposal since the NPV is negative.
Year Cash Flow 11% PV Factor

0 $(345,000) 1.0000
$(345,000)
1 102,000 .9009
91,892
2 126,000
.8116
102,262
3 114,000
.7312
83,357
4
102,000
.6587
67,187
NPV
$ (302)
PV
(CMA)
55. a. The benefits of a postcompletion audit program for capital expenditure
projects include these:
The comparison of actual results with projected results to validate that a
project is meeting expected performance or to take corrective action or
terminate a project not achieving expected performance.
An evaluation of the accuracy of projections from different departments.
The improvement of future capital project revenue and cost estimates
through analyzing variations between expected and actual results from
previous projects and the motivational effect on personnel arising from the
knowledge that a postinvestment audit will be done.
468
Chapter 15
b. Practical difficulties that would be encountered in collecting and accumulating

information include:
Isolating the incremental changes caused by one capital project from all
the other factors that change in a dynamic manufacturing and/or
marketing environment.
Identifying the impact of inflation on all costs in the capital project
justification.
Updating of the original proposal for approval of changes that m ay have
occurred after the initial approval.
Having a sufficiently sophisticated information accumulation system to
measure actual costs incurred by the capital project.
Allocating sufficient administrative time and expenses for the
postcompletion audit.
(CMA adapted)
56. a. Year Revenue
VC
FC Net Cash Flow
1 - 4 $115,000 $ 69,000 $20,000 $ 26,000
5-8
175,000 105,000 20,000
50,000
9 - 10
100,000
60,000 20,000
20,000
Year
0
$(140,000)
14
26,000
5-8
50,000
9 10
20,000
10
10,000
NPV
Cash Flow PV Factor

1.0000
$(140,000)
3.1699
82,417
2.1651
108,255
.8096
16,192
.3855
3,855
$ 70,719
b. Year Revenue
VC
FC
1-4
$120,000 $ 78,000 $15,000
5-8
200,000 130,000 17,500
9 - 10 103,000
66,950 25,000
Year Cash Flow PV Factor
0
$(127,500) 1.0000 $(127,500)
14
27,000
3.1699
85,587
58
52,500 2.1651
113,668
9 10
11,050 .8096
8,946
10
23,500
.3855
9,059
NPV
$ 89,760
PV
Net Cash Flow

$27,000
52,500
11,050
PV
c. The biggest factors are the increased level of variable costs, the additional
working capital, the lower initial revenues, and the lower cost of production
equipment.
469
Chapter 15
57. a.
Cash
Cash
Net
Cumulative
Year Receipts
Expenses
Inflows Cash Flows
1 $3,000,000 $2,530,000 $ 470,000 $ 470,000
2 3,200,000 2,400,000
800,000 1,270,000
3 3,720,000 2,582,000
1,138,000 2,408,000
4 5,120,000 3,232,000 1,888,000 4,296,000
5 6,400,000 3,520,000 2,880,000 7,176,000
Payback = 4 + (($6,400,000 - $4,296,000) $2,880,000) = 4.73 years
b. Year
Cash Flow PV Factor PV
0 $(6,400,000) 1.0000 $(6,400,000)
1
470,000 .9259
435,173
2
800,000 .8573
685,840
3 1,138,000 .7938
903,344
4 1,888,000 .7350 1,387,680
5 2,880,000 .6806 1,960,128
6 2,880,000 .6302
1,814,976
7 1,632,000 .5835
952,272
8
648,000 .5403
350,114
NPV
$ 2,089,527
c. Year
Net Income
1 $ (330,000)
2
0
3
338,000
4 1,088,000
5 2,080,000
6
2,080,000
7
832,000
8 (152,000)
$5,936,000
Average annual income = $5,936,000 8 = $742,000
Average Investment = (Cost + Salvage) 2
= ($6,400,000 + $0) 2 = $3,200,000
ARR = $742,000 $3,200,000 = 23.19%
d. Although there are no stated evaluation criteria for accounting rate of return or
payback, the NPV criterion meets the standard threshold of $0. Therefore,
the product line should be added.
470
Chapter 15
58. a. Initial cost: t0 = $(1,460,000) + $340,000 = $(1,120,000)

Annual cash flow:
Additional revenue ($1.20 x 220,000)
$264,000
Labor savings
60,000
Other operating savings ($192,000 - $80,000) 112,000
Total
$436,000
NPV = $(1,120,000) + ($436,000 x 6.1446) = $1,559,046

b. Discount factor = $1,120,000 $436,000 = 2.5688
The IRR exceeds numbers reported in the present value appendix. By
computer, the IRR is found to be 37%.
c. $1,120,000 $436,000 = 2.5688 years
d. ARR = ($436,000 - $62,000) (($1,120,000 + $0) 2) = 66.79%
e. Because the project generates a very high NPV and IRR, as well as a high
ARR, the firm should buy the new equipment.
(CMA adapted)

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CHAPTER 15

19. No solution provided.

Payback = 4 years + ($320,000 - $276,000)/$50,000 = 4.88 years

Point in Time Cash Flows PV Factor

30. a. Straight-line method

In the final year, the remaining undepreciated cost is expensed.

Point in Time Cash Flows

The project is acceptable because the NPV is positive.

The project is acceptable. Note, because of the more rapid depreciation

Point in Time Cash Flows

The project is unacceptable because the NPV is negative

The project is acceptable.

b. Ranking according to:

b. $80,000 $21,104 = 3.79 years

discount factor for 48 months, 1%

40. a. PV = future value x discount factor

41. a. Change in net income = $20,000,000 - ($72,000,000 5) = $5,600,000

b. Payback = $40,000 $10,400 per year = 3.85 years

b. Year Cash Flow Cumulative Cash Flow

Payback = 5 + (($190,000 - $169,000) $30,000) = 5.7 years

Amount: ($41,000) $5,900 $8,100 $8,300 $8,000 $8,000 $8,300 $9,200

Cash Flow Cumulative

Payback = 5 years + (($41,000 - $38,300) $8,300) = 5.33 years

b. No, the NPV is negative; therefore this is an unacceptable project.

c. PI = ($4,678,051 + $266,040) $5,000,000 = 0.99

PI = $640,188 $568,000 = 1.13

Discount factor of 4.7333 is between 13.0 and 13.5%; therefore, to the

Cash Flow Discount

51. a. Cash flow after tax (CFAT):

b. Year Net Cash Flow Cumulative Cash Flow

Payback = 3 years + (($320,000 300,520) $83,100) = 3.23 years.

Net present value:

52. a. Maple Commercial Plaza:

b. Maple Commercial Plaza:

Includes $32,000 from tax loss on sale (0.40

Includes $216,000 from tax loss on sale (0.40

c. After-tax NPV, Maple Commercial Plaza:

d. After-tax NPV, Hightower:

Rental por tion of cash flow = $620,000

In this circumstance, Maple Commercial Plaza is the preferred investment.

b. Discount factor = $1,500,000 $289,286 = 5.1852

Year Cash Flow 11% PV Factor

b. Practical difficulties that would be encountered in collecting and accumulating

Cash Flow PV Factor

Net Cash Flow

58. a. Initial cost: t0 = $(1,460,000) + $340,000 = $(1,120,000)

NPV = $(1,120,000) + ($436,000 x 6.1446) = $1,559,046

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