Ch15 Raiborn SM

170
Chapter 15
CHAPTER 15
CAPITAL BUDGETING
QUESTIONS
1.
Acapitalassetisalonglivedassetacquiredbyafirm.Capitalassetsprovide
the essential production and distributional capabilities required by all
organizations.
2.
Cashflowsarethefocusofcapitalbudgetinginvestmentsjustascashflows
arethefocusofanyinvestment.Accountingincomeultimatelybecomescashflow
butisreportedbasedonaccruals,deferrals,andotheraccountingassumptionsand
conventions.Theseaccountingpracticesandassumptionsdetractfromthepurity
ofcashflowsand,therefore,arenotusedincapitalbudgeting.
3.
Timelinesprovideclearvisualmodelsofaprojectsexpectedcashinflowsand
outflowsforeachpointintime.Thesegraphicsprovideanefficientandeffective
meanstohelporganizetheinformationneededtoperformcapitalbudgetinganalyses.
4.
The payback method measures the time expected for a firm to recover its
investmentinaproject.Themethodignoresthereceiptsexpectedtooccurafterthe
investmentisrecoveredandignoresthetimevalueofmoney.
5.
Return of capital means the investor is receiving the principal that was
originallyinvested.Return oncapitalmeanstheinvestorisreceivinganamount
earnedontheinvestment(i.e.,anamountinexcessoftheoriginalinvestment).
6.
AprojectsNPVisthepresentvalueofallcashinflowslessthepresentvalue
ofallcashoutflowsassociatedwiththeproject.IfNPViszero,theprojectis
acceptablebecause,inthatcase,itwillexactlyearntherequiredrateofreturn.
Also,whenNPVequalszero,theprojectsinternalrateofreturnequalsthecostof
capital.
7.
ItishighlyunlikelythattheestimatedNPVwillexactlyequaltheactualNPV
achieved because of the number of estimates necessary in the original
computation.Theseestimatesincludeprojectlifeandtimingandamountsofcash
inflowsandoutflows.Theoriginalinvestmentmayalsoincludeanestimateofthe
amountofworkingcapitalneededatthebeginningoftheprojectlife.
8.
The profitability index (PI) is calculated by dividing the discounted cash

inflowsbytheinitialinvestment.TheNPVmethodsubtractstheinitialinvestment
fromthediscountednetcashinflowstoarriveatthenetpresentvalue.Thus,each
computationusesthesameamountsindifferentways.Bymeasuringtheexpected
dollarsofdiscountedcashinflowsperdollarofprojectinvestment,PIattemptsto
measuretheplannedefficiencyoftheuseofthemoney(i.e.,outputtoinput).API
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accessible website, in whole or in part.
171
Chapter 15
equaltoorgreaterthan1isequivalenttoaNPVequaltoorgreaterthanzeroand
indicatesthattheinvestmentwillprovideanacceptablereturnoncapital.
9.
TheIRRistheratethatwouldcausetheNPVofaprojecttoequalzero.A
projectisconsideredpotentiallysuccessful(allotherfactorsbeingacceptable)if
thecalculatedIRRequalsorexceedsthecompanyscostofcapital.
10.
Theamountofdepreciationforayearisonefactorthathelpsdeterminethe
amountofcashoutflowforincometaxes.Therefore,althoughdepreciationisnot
acashflowitemitself,itdoesaffectthesizeofanotheritem(incometaxes)thatis
acashflow.
11.
Thefourquestionsare:
Istheactivityworthyofaninvestment?
Whichassetscanbeusedfortheactivity?
Oftheassetsavailableforeachactivity,whichisthebestinvestment?
Ofthebestinvestments forallworthwhileactivities,inwhichones
shouldthecompanyinvest?
1.
2.
3.
4.
12.
Riskisdefinedasthelikelyvariabilityofanassetsfuturereturns.Aspectsof
aprojectforwhichriskisinvolvedare:
Lifeoftheasset
Amountofcashflows
Timingofcashflows
Salvagevalueoftheasset
Taxratesoftheorganization
As risk increases, it should be taken into consideration in capital budgeting
analysis through raising the discount rate (or some other acceptable method)
which,inturn,lowerstheNPVofaproject.
13.
In capital budgeting, sensitivity analysis is used to

determinethelimitsofvalueforinputvariables(e.g.,discountrate,cashflows,
assetlife,etc.)beyondwhichtheprojectsoutcomewillbesignificantlyaffected.
Thisprocessgivesthedecisionmakeranindicationofhowmuchroomthereisfor
error in estimates for input variables and which input variables need special
attention.
14.
Postinvestment audits are performed to determine

whether the realized return matches the expected return on a project.
Postinvestmentauditsaretypicallyperformedatorneartheendofaprojectslife.
15.
The time value of money refers to the concept that

moneyhastimebasedearningspower.Moneycanbeloanedorinvestedtoearna
rateofreturn.Presentvalueisalwayslessthanfuturevaluebecauseofthetime
valueofmoney.Afuturevaluemustbediscountedtodetermineitsequivalent
Chapter 15
(butsmaller)presentvalue.Thediscountingprocessstripsawaytheimputedrate
ofreturninfuturevalues,thuspresentvaluesarelessthanfuturevalues.
16.
ARR=AverageannualprofitsAverageinvestment
Unliketherateusedtodiscountcashflowsortocomparetothecostofcapitalrate,
theARRisnotadiscountratetoapplytocashflows.Itismeasuredfromaccrual
basedaccountinginformationandisnotintendedtobeassociatedwithcashflows.
172
173
Chapter 15
EXERCISES
17.
Investorsareultimatelymostinterestedincashflows.
Investorscannotspendaccountingincome;theycanonlyspendthecashthatis
derivedfromtheirinvestmentinthefirm.Investorsareinterestedinaccounting
earningsbecausetheyrevealinformationaboutpresentandfuturecashflowsthat
isnotrevealedinexaminingonlycashflows.Hence,accountingearningsareonly
usefultoinvestorsifthoseearningshelpinformtheinvestorsaboutcashflows.
Cashflows
Period:
(Purchase)
Savings
18.
0
3,000,000
Accountingearnings
Period:
0
Expensesavings
Depreciation
Increase in
accounting earnings
19.
20.
900,000
900,000
3
900,000
900,000
900,000
3
4
900,000 900,000
600,000 600,000
5
900,000
600,000
1
2
900,000 900,000
600,000 600,000
300,000
300,000
300,000
300,000
300,000
Nosolutionprovided.
Themainpointmadeshouldbethatstockpricesreflectthefirmsexpectedfuture
cashflowsdiscountedatanappropriateriskadjusteddiscountrate.Theriskadjusted
discountrateisafunctionofboththespecificsecuritysriskandtheprevailing
marketinterestrates.Asmarketinterestrateschange,thevalueofsecuritieschange
alsoespeciallythosethathavedistantfuturecashflowsthatcompriseasignificant
portionofthesecuritysvalue,e.g.,growthstocks.
21. a.Payback=$3,000,000$600,000peryear=5years
b.
Year
1
2
3
4
5
6
7
8
9
10
Amount
$300,000
300,000
300,000
300,000
300,000
400,000
400,000
400,000
400,000
400,000
CumulativeAmount
$300,000
600,000
900,000
1,200,000
1,500,000
1,900,000
2,300,000
2,700,000
3,100,000
3,500,000
Thepaybackiseightyearsplus[(3,000,0002,700,000)400,000]or8.75
years.
Chapter 15
22.
174
a. Investment = $140,000 + $180,000 = $320,000

Year
Amount
CumulativeAmount
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
Payback=4years+[($320,000$276,000)$50,000]=4.9years
Based on the payback criterion, Houston Fashions should not invest in the
proposedproductline.
b.
Yes. Houston Fashions should also use a discounted cash flow

techniquesoastoconsiderboththetimevalueofmoneyandthecashflows
thatoccurafterthepaybackperiod.
PointinTime
CashFlows
0 $(1,800,000)
1
280,000
2
280,000
3
340,000
4
340,000
5
340,000
6
288,800
7
288,800
8
288,800
9
260,000
10
260,000
NPV
PVFactor
PresentValue
1.0000 $(1,800,000)
0.8929
250,012
0.7972
223,216
0.7118
242,012
0.6355
216,070
0.5674
192,916
0.5066
146,306
0.4524
130,653
0.4039
116,646
0.3606
93,756
0.3220
83,720
$(104,693)
BasedontheNPV,thisisanunacceptableinvestment.
24. a.
Thecontributionmarginofeachpartis$1(or$7.50$6.50)
Contributionmarginperyear=$1100,000=$100,000
PointinTime
CashFlows
0
$(500,000)
18
(20,000)
18 100,000
NPV
b.
c.
PVFactor
PresentValue
1.0000
$(500,000)
5.5348
(110,696)
5.5348
553,480
$(57,216)
BasedontheNPV,thisisnotanacceptableinvestment.
Otherconsiderationswouldincludewhetherrefusingtoproducethis
partforthecustomerwouldcausealossofotherbusinessfromthatcustomer.
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Chapter 15
Thecompanyshouldalsoconsidergoingbacktothecustomerandaskingfora
higherpricethatwouldcausetheprojecttohaveapositiveNPV.
Chapter 15
176
25.
PI=PVofcashinflowsPVofcashoutflows
=($18,000+$240,000)$240,000=1.08
26. a.
PVofinflows:$91,0006.4177 = $584,011
PVofinvestment:$600,000
PI=$584,011$600,000=0.97
b.
CedarCityPublicTransportationshouldnotaddthebusroutebecause
thePIislessthan1.00.
c.
Tobeacceptable,aprojectmustgenerateaPIofatleast1;aPIgreater
than1equatestoanNPV>0.
27. a.
PV=DiscountfactorAnnualcashinflow
$700,000=Discountfactor$144,000
Discountfactor=$700,000$144,000=4.8611
TheIRRis13percent(roundedtothenearestwholepercent).
b.
percent.
c.
Yes.TheIRRonthisproposalisgreaterthanthefirmshurdlerateof7
$700,000=5.9713Annualcashflow
Annualcashflow=$700,0005.9713
Annualcashflow=$117,227
28. a.
PV=DiscountfactorAnnualcashinflow
$1,800,000=Discountfactor$300,000
Discountfactor=$1,800,000$300,000=6.0000
TheIRRis10.5percent(roundedtothenearesthalfpercent).
TheprojectisacceptablebecausetheIRRexceedsthediscountrate.
b.
29.
Themainqualitativefactorswouldbetheeffectofthetechnologyon
theperceivedqualityofthefoodthatisprocessedbythenewmachinery.An
additionalconsiderationwouldbetheeffectofthetechnologyonemployees,
particularlyiftheinvestmentwouldcauselayoffs.
Investmentcost=$375,000Discountfactorfor14%,7years
=$375,0004.2883=$1,608,113
NPV=$375,000Discountfactor(10%,7years)$1,608,113
=($375,0004.8684)$1,608,113=$217,537
30. a.
Annualdepreciation=$1,000,0008years=$125,000peryear
Taxbenefit=$125,0000.30=$37,500
PV=$37,5005.7466=$215,498
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Chapter 15
b.Acceleratedmethod
$1,000,0000.300.400.9259
$600,0000.300.400.8573
$360,0000.300.400.7938
$216,0000.300.400.7350
$129,600*0.300.6806
Total
=
=
=
=
=
$111,108
61,726
34,292
19,051
26,462
$252,639
Inthefinalyear,theremainingundepreciatedcostisexpensed.
c. Thedepreciationbenefitcomputedin(b)exceedsthatcomputedin(a)solely
becauseofthetimevalueofmoney.Thedepreciationmethodin(b)allowsfor
fasterrecaptureofthecost;therefore,thereislessdiscountingofthefuturecash
flows.
31. a. SLD=$18,000,0008years=$2,250,000peryear
BeforetaxCF
Lessdepreciation
BeforetaxNI
Lesstax(30%)
NI
Adddepreciation
AftertaxCF
$3,100,000
(2,250,000)
$850,000
(255,000)
$595,000
2,250,000
$2,845,000
PointinTime
CashFlows
0
$(18,000,000)
18 2,845,000
NPV
PVFactor PresentValue
1.0000 $(18,000,000)
6.4632
18,387,804
$387,804
TheprojectisacceptablebecausetheNPVispositive.
b.
BeforetaxCF
Lessdepreciation
BeforetaxNI
Tax(taxbenefit)
AftertaxNI
Adddepreciation
AftertaxCF
Years1and2
$3,100,000
(4,140,000)
$(1,040,000)
(312,000)
$(728,000)
4,140,000
$3,412,000
PointinTime
CashFlows
0
$(18,000,000)
12
3,412,000
38
2,656,000
NPV
Years38
$3,100,000
(1,620,000)
$1,480,000
444,000
$1,036,000
1,620,000
$2,656,000
PVFactor PresentValue
1.0000 $(18,000,000)
1.8594
6,344,273
4.6038
12,227,693
$571,966
Chapter 15
The equipment investment is acceptable. Note, because of the more rapid

depreciationusedin(b)relativeto(a),theNPVismorepositivein(b)thanin
(a).
178
179
Chapter 15
c. BeforetaxCF
Lessdepreciation
BeforetaxNI
Lesstax(40%)
NI
Adddepreciation
AftertaxCF
$3,100,000
(2,250,000)
$850,000
(340,000)
$510,000
2,250,000
$2,760,000
PointinTime
CashFlows
0 $(18,000,000)
18 2,760,000
NPV
PVFactor
PresentValue
1.0000 $(18,000,000)
6.4632
17,838,432
$(161,568)
TheequipmentinvestmentisunacceptablebecausetheNPVisnegative.
BeforetaxCF
Lessdepreciation
BeforetaxNI
Tax(taxbenefit)
AftertaxNI
Adddepreciation
AftertaxCF
Years1and2
$3,100,000
4,140,000
$(1,040,000)
(416,000)
$(624,000)
4,140,000
$3,516,000
PointinTime
CashFlows
0 $(18,000,000)
12 3,516,000
38 2,508,000
NPV
Years38
$3,100,000
1,620,000
$1,480,000
592,000
$888,000
1,620,000
$2,508,000
PVFactor
PresentValue
1.0000 $(18,000,000)
1.8594
6,537,650
4.6038
11,546,330
$83,980
Theequipmentinvestmentisacceptable.
32. a. Tax:$99,000$18,000=$81,000
Financialaccounting:$99,000$35,000=$64,000
b. CFAT=CurrentmarketvalueTaxes
=$37,000[($37,000$18,000)0.30]=$31,300
c. CFAT=$9,000[($9,000$18,000)0.30]=$11,700
33. a. payback
b. NPV,PI
c. IRR
d. payback,NPV,PI,IRR
e. allmethods
f. payback
g. ARR
34. a. payback,NPV,PI,IRR
Chapter 15
180
b. payback
c. ARR
d. payback,ARR
e. payback,NPV,PI,IRR
f. allmethods
g. IRR
h. payback,IRR,ARR,PI
35. a.ProjectName
Filmstudios
Cameras&equipment
Landimprovement
Motionpicture#1
Motionpicture#2
Motionpicture#3
Corporateaircraft
NPV
$3,578,910
1,067,920
2,250,628
1,040,276
1,026,008
3,197,320
518,916
b. Rankingaccordingto:
NPV
1.
Film
studios
2.
MP#3
3.
Land
improvement
4.
Cameras&
equip.
5.
MP#1
6.
MP#2
7.
Corp.
aircraft
PI
1.18
1.33
1.45
1.06
1.09
1.40
1.22
IRR
13.03%
18.62
19.69
12.26
14.09
21.32
18.15
PI
Landimprovement
IRR
MP#3
MP#3
Cameras&equip.
Landimprovement
Cameras&equip.
Corp.aircraft
Corp.aircraft
Filmstudios
MP#2
MP#1
MP#2
Filmstudios
MP#1
c. Suggestedpurchases:
NPV
1.
Motion picture #3 @
$3,197,320
$8,000,000
2.
Land improvement @
2,250,628
$5,000,000
3.
Cameras & equipment @
1,067,920
$3,200,000
4.
Corporate aircraft @
518,916
$2,400,000
TotalNPV
$7,034,784
36. a. CashflowAnnuityfactor=$160,000
Cashflow3.7908=$160,000
Cashflow=$42,207
b. $160,000$42,207=3.79years
181
Chapter 15
37. a. NPV=($28,0004.8684)$100,000=$36,315
b.
Annuityfactor$28,000=$100,000
Annuityfactor=$100,000$28,000=3.5714
Thisfactorcorrespondsmostcloselyto20%
38. PV=FVDiscountfactor
$80,000=FV0.7473
FV=$80,0000.7473=$107,052
39. Cost=$8,000+PV($800annuity)=$8,000+($80037.9740*)=$38,379.20
*
Discountfactorfor48months,1%
Chapter 15
182
40. a. PV=FuturevalueDiscountfactor
=$50,0000.6302
=$31,510shouldbeinvestedtoachievethegoal
b. PV=FuturevalueDiscountfactor
=$400,0000.3769
=$150,760wouldbeequivalenttoday
c. PV=FuturevalueDiscountfactor
=$60,0000.2146
=$12,876
d. Presentvalue=AnnuityAnnuitydiscountfactor
=$200,0003.9927
=$798,540
e. Year1receipt:
Year2receipt:
Year3receipt:
Year4receipt:
Year5receipt:
Year6receipt:
Year7receipt:
Year8receipt:
Year9receipt:
Year10receipt:
Presentvalue
$50,0000.9346=
$55,0000.8734=
$60,0000.8163=
$100,0000.7629=
$100,0000.7130=
$100,0000.6663=
$100,0000.6228=
$100,0000.5820=
$70,0000.5439=
$45,0000.5084=
$46,730
48,037
48,978
76,290
71,300
66,630
62,280
58,200
38,073
22,878
$539,396
f. No.Usinganydiscountrateabove0,thepresentvalueofthefutureannual
cashflowsiswellbelow$1,000,000.
41. a. Changeinnetincome=$20,000,000($72,000,0005)=$5,600,000
ARR=$5,600,000($72,000,0002)=15.6%
Payback=$72,000,000$20,000,000peryear=3.6years
b. No.Althoughthedredgemeetsthepaybackcriterion,itfailstomeettheARR
criterionof18percent.
42.a.Annualcashreceipts
Cashexpenses
Netcashflowbeforetaxes
Depreciation
Incomebeforetax
Taxes
Netincome
Depreciation
Annualaftertaxcashflow
$15,000
(3,000)
$12,000
(6,667)
$5,333
(1,600)
$3,733
6,667
$10,400
183
Chapter 15
b. Payback=$40,000$10,400peryear=3.8years
c. ARR=$3,733($40,0002)=18.7%
Chapter 15
184
PROBLEMS
43. a. Aleaseisfoundappealingbyconsumersbecauseitoftenresultsinalower
monthly payment than that which would have been required to purchase a
specific car. Alternatively, the consumer could opt to make the payment
required to purchase the specific car but obtain a more expensive car under
lease financing.
b. No.Aconsumershouldbeprovidedwithallnecessaryinformationtomakea
faircomparisonbetweentheleaseandpurchasealternative.
c. Asanaccountant,youcouldprovideafinancialcomparisonoftheleaseand
purchase alternatives. Using a discounted cash flow approach, you could
comparethepresentvalueofpurchasingthevehicletothepresentvalueof
leasingthevehicle.
44. a. Althoughthe8percenthurdleratemaybeappropriateformostprojects,it
may be inappropriate to insist that a project such as a pollution abatement
projectberequiredtomeetanyfinancialhurdlerate.
b.
In the future, the company could face not only

significantfinesfromgovernmentregulators,butalsofinancialclaimsfiledby
personsharmedbythearsenic.
c.
Hernandez should justify the investment based

both on the potential future financial claims and that it is the socially and
ethicallycorrectactionforthecompanytotake.
45.a.($000somitted)
Investment
NewCM
Oper.costs
Cashflow
b. Year
1
2
3
4
5
6
t0
(190)
(190)
CashFlow
$40,000
33,000
33,000
33,000
30,000
30,000
t1
t2
t3
t4
t5
t6
t7
t8
60 60 60 60 60 60 60 60
20 27 27 27 30 30 30 33
40
33
33
33
30
30
30
27
CumulativeCashFlow
$40,000
73,000
106,000
139,000
169,000
199,000
Payback=5+[($190,000$169,000)$30,000]=5.7years
185
Chapter 15
c. Time
CashFlow
0 $(190,000)
1
40,000
2
33,000
3
33,000
4
33,000
5
30,000
6
30,000
7
30,000
8
27,000
NPV
46.a.Time:
Amount:
b.Year
1
2
3
4
5
6
t0
($41,000)
PVFactorfor8% PresentValue
1.0000 $(190,000)
0.9259
37,036
0.8573
28,291
0.7938
26,195
0.7350
24,255
0.6806
20,418
0.6302
18,906
0.5835
17,505
0.5403
14,588
$(2,806)
t1
$5,900
CashFlow
$5,900
8,100
8,300
8,000
8,000
8,300
t2
$8,100
t3
$8,300
t4
$8,000
t5
$8,000
t6
$8,300
Cumulative
$5,900
14,000
22,300
30,300
38,300
46,600
c.
CashFlow
Description
Purchasethetruck
Costsavings
Costsavings
Costsavings
Costsavings
Costsavings
Costsavings
Costsavings
NPV
47.a.Year
0
17
7
NPV
Time Amount
t0 $(41,000)
t1
5,900
t2
8,100
t3
8,300
t4
8,000
t5
8,000
t6
8,300
t7
9,200
CashFlow
$(5,000,000)
838,000
400,000
Discount
Present
Factor
Value
1.0000 $(41,000)
0.9259
5,463
0.8573
6,944
0.7938
6,589
0.7350
5,880
0.6806
5,445
0.6302
5,231
0.5835 5,368
$(80)
PVFactor
PV
1.0000 $(5,000,000)
5.5824
4,678,051
0.6651
266,040
$(55,909)
b. No,theNPVisnegative;thereforethisisanunacceptableproject.
t7
$9,200
Chapter 15
186
c. PI=($4,678,051+$266,040)$5,000,000=0.99
d. PVofannualcashflows=$5,000,000$266,040
PVofannualcashflows=$4,733,960
PVofannualcashflows=Annualcashflow5.5824
$4,733,960=Annualcashflow5.5824
Annualcashflow=$4,733,9605.5824=$848,015
Minimumlaborsavings=$848,015+Operatingcosts
=$848,015+$112,000
=$960,015
e. Thecompanyshouldconsiderthequalityofworkperformedbythemachine
comparedtothequalityofworkperformedbytheindividuals;thereliabilityof
the mechanical process compared to the manual process; and perhaps most
importantly, the effect on worker morale and the ethical considerations in
displacing14workers.
48. a.Paybackperiod=$140,000($47,500$8,500)=3.6years
Theprojectdoesnotmeetthepaybackcriterion.
b. Discountfactor=InvestmentAnnualcashflow
=$140,000$39,000=3.5897
Discountfactorof3.5897indicatesIRR4%
ThisisanunacceptableIRR.
c. Fostershouldconsidertwomainfactors:(1)theeffectofthecomputersystem
ontaxreturnaccuracyandqualityofservicedeliveredtoclientsand(2)the
effect of firing one employee on both the dismissed employee and the
remainingemployees.
49. a.Theincrementalcostofthereplacementequipment:$580,000$12,000=
$568,000
Description
Incrementalcost
Costsavings
NPV
Time
t0
t1t8
CashFlow
Amount
$(568,000)
120,000
Discount
Factor
1.0000
5.3349
Present
Value
$(568,000)
640,188
$72,188
PI=$640,188$568,000=1.1
Yes,thereplacementequipmentshouldbepurchasedbecausetheNPV>0and
thePI>1.
187
Chapter 15
b. Payback=$568,000120,000peryear=4.7years
c. NetinvestmentAnnualannuity=DiscountfactorofIRR
$568,000120,000=4.7333
Discountfactorof4.7333isbetween13.0and13.5percent;therefore,tothe
nearestwholepercent,theIRRis13percent.
50. a.Computationofnetannualcashflow:
Increaseinrevenues
Increaseincashexpenses
Increaseinpretaxcashflow
Lessdepreciation
Incomebeforetax
Incometaxes(30percent)
Netincome
Adddepreciation
Aftertaxcashflow
Description
Initialcost
Annualcashflow
Time
t0
t1
t20
$46,000
(21,000)
$25,000
(9,750)
$15,250
(4,575)
$10,675
9,750
$20,425
CashFlow Discount
Amount
Factor
$(195,000) 1.0000
20,425
9.1286
NPV
Present
Value
$(195,000)
186,452
$(8,548)
b. ThisisnotanacceptableinvestmentbecausetheNPVislessthan$0.
c. MinimumannualaftertaxcashflowDiscountfactor=$195,000
Minimumannualaftertaxcashflow9.1286=$195,000
Minimumannualaftertaxcashflow=$21,361
$21,361=(Minimumcashrevenues$21,000$9,750)(1Taxrate)+$9,750
$11,611=(Minimumcashrevenues$21,000$9,750)(10.30)
$16,587=Minimumcashrevenues$30,750
Minimumcashrevenues=$47,337
Proof:Computationofnetannualcashflow:
Increaseinrevenues
Increaseincashexpenses
Increaseinpretaxcashflow
Lessdepreciation
Incomebeforetax
Incometaxes(30percent)
Netincome
Adddepreciation
Aftertaxcashflow
$47,337
(21,000)
$26,337
(9,750)
$16,587
(4,976)
$11,611
9,750
$21,361
Chapter 15
188
51. a.Cashflowaftertax(CFAT):
Year
PreTaxCF Depreciation
1
$104,000
$64,000
2
118,000
102,400
3
118,000
60,800
4
102,000
48,000
5
86,000
44,800
Timeline:
t0
$(320,000)
b.Year
1
2
3
4
t1
$90,000
t2
$112,540
NetCashFlow
$90,000
112,540
97,980
83,100
Tax
$14,000
5,460
20,020
18,900
14,420
t3
$97,980
CFAT
$90,000
112,540
97,980
83,100
71,580
t4
$83,100
t5
$71,580
CumulativeCashFlow
$90,000
202,540
300,520
383,620
Netpresentvalue:
Time
0
1
2
3
4
5
NPV
Amount
$(320,000)
90,000
112,540
97,980
83,100
71,580
DiscountFactor
PresentValue
1.0000 $(320,000)
0.9259
83,331
0.8573
96,481
0.7938
77,777
0.7350
61,079
0.6806
48,717
$47,385
Profitabilityindex=($320,000+$47,385)$320,000=1.1
IRRis14percent.
52. a. MapleCommercialPlaza:
t0
t1t10
$(800,000) $210,000
HighTower:
t0
$(3,400,000)
t1t10
$830,000
b.MapleCommercialPlaza:
Calculationofannualcashflow:
Pretaxcostsavings
Depreciation($800,00025)
Pretaxincome
t10
$400,000
t10
$1,500,000
$210,000
(32,000)
$178,000
189
Chapter 15
Taxes(40percent)
Aftertaxincome
Depreciation
Aftertaxcashflow
t0
$(800,000)
(71,200)
$106,800
32,000
$138,800
t1t10
$138,800
t10
$432,000*
Includes$32,000fromtaxlossonsale[0.40($400,000$480,000)]
Chapter 15
190
HighTower:
Calculationofannualcashflow:
Pretaxcostsavings
Depreciation($3,400,00025)
Pretaxincome
Taxes
Aftertaxincome
Depreciation
Aftertaxcashflow
t0
$(3,400,000)
t1t10
$552,400
$830,000
(136,000)
$694,000
(277,600)
$416,400
136,000
$552,400
t10
$1,716,000*
Includes$216,000fromtaxlossonsale[0.40($1,500,000$2,040,000)]
c. AftertaxNPV,MapleCommercialPlaza:
Year
Amount DiscountFactor PresentValue
0
$(800,000)
1.0000 $(800,000)
110
138,800
5.8892
817,421
10
432,000
0.3522
152,150
NPV
$169,571
AftertaxNPV,Hightower:
Year
Amount
DiscountFactor
0
$(3,400,000)
1.0000
110
552,400
5.8892
10
1,716,000
0.3522
NPV
PresentValue
$(3,400,000)
3,253,194
604,375
$457,569
BasedontheNPVcriterion,Hightoweristhepreferredinvestment.
d.
Year
0
110
110
10
NPV
AftertaxNPV,Hightower:
Amount
DiscountFactor PresentValue
$(3,400,000)
1.0000 $(3,400,000)
180,400
5.8892
1,062,412
372,000*
4.1925
1,559,610
1,716,000
0.3522
604,375
$(173,603)
Rentalportionofcashflow=$620,000(1Taxrate)
=$620,0000.60
=$372,000
Inthiscircumstance,MapleCommercialPlazaisthepreferredinvestment.
53. a.Depreciationperyear=$1,500,00014=$107,143
Beforetaxcashflows=[3000.80($70$20)50]$250,000
=$350,000peryear
191
Chapter 15
BeforetaxCF
Lessdepreciation
Incomebeforetax
Lesstax(25%)
Netincome
Adddepreciation
Aftertaxcashflow
$350,000
(107,143)
$242,857
(60,714)
$182,143
107,143
$289,286
PVof14yr.annuityof$289,286@10%
Lesscost
NPV
$2,131,083
(1,500,000)
$631,083
b.
Discountfactor=$1,500,000$289,286=5.1852
Discountfactorof5.1852correspondsto17%.
c.
CashflowDiscountfactor=$1,500,000
Cashflow(7.3667)=$1,500,000
Cashflow=$203,619
d.
$1,500,000$289,286=5.1852
5.1852isthediscountfactorfor10percentandfallsbetweenthe10percent
discountfactorscorrespondingtosevenandeightyears.
54.a.Incrementalannualaftertaxcashflows:
Purchaseofnewequipment
Onetimetransferexpense,netoftax($80,0000.6)
Saleofoldequipment,netoftax($5,0000.6)
Totalinitialcashoutflow
Year0
$(300,000)
(48,000)
3,000
$(345,000)
ANNUALOPERATIONS
Year1
Year2
Year3
Cashoperating
savings
$90,000
$150,000
$150,000
Lesstaxeffect(40%)
(36,000) (60,000)
(60,000)
Cashsavingsaftertax
$54,000
$90,000
$90,000
Depr.taxshield
(seesched.below)
48,000
36,000
24,000
Aftertaxoperating
cashflows
$102,000
$126,000
$114,000
Year4
$150,000
(60,000)
$90,000
12,000
$102,000
DepreciationSchedule
DepreciableBase:$300,000
Life:FourYearLimit
Method:SumoftheYearsDigits
Chapter 15
Year
1
2
3
4
b.
192
Rate
4/10
3/10
2/10
1/10
Depreciation
$120,000
90,000
60,000
30,000
Depr.Shield
$48,000
36,000
24,000
12,000
ThecompanyshouldrejecttheproposalsincetheNPVisnegative.
Year
0
1
2
3
4
NPV
CashFlow
$(345,000)
102,000
126,000
114,000
102,000
11%PVFactor
PresentValue
1.0000 $(345,000)
0.9009
91,892
0.8116
102,262
0.7312
83,357
0.6587
67,187
$(302)
(CMAadapted)
55. a. Thebenefitsofapostinvestmentauditprogramforcapitalexpenditureprojects
include:
b.
Comparison of actual and projected results to validate that a project is

meetingexpectedperformance,totakeanynecessarycorrectiveaction,or
toterminateaprojectnotachievingexpectedperformance.
Evaluationoftheaccuracyofprojectionsfromdifferentdepartments.
Improvement of future capital project revenue and cost estimates by
analyzing variations between expected and actual results from previous
projects.
Motivationaleffectonpersonnelarisingfromtheknowledgethatapost
investmentauditwillbedone.
Practicaldifficultiesthatwouldbeencounteredincollecting
andaccumulatinginformationinclude:
Isolatingtheincrementalchangescausedbyonecapitalprojectfromallthe
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 the original proposal for approval of changes that may have
occurredaftertheinitialapproval.
Having a sufficiently sophisticated information accumulation system to
measureactualcostsincurredbythecapitalproject.
Allocatingsufficientadministrativetimeandexpensesforthepostinvestment
audit.
(CMAadapted)
56. a. Year
14
58
Revenue
$115,000
175,000
VC
$69,000
105,000
FC
$20,000
20,000
NetCashFlow
$26,000
50,000
193
Chapter 15
910
100,000
60,000
20,000
20,000
Chapter 15
194
Year
0
14
58
910
10
NPV
CashFlow
$(140,000)
26,000
50,000
20,000
10,000
b.Year
14
58
910
Revenue
$120,000
200,000
103,000
Year
0
14
58
910
10
NPV
CashFlow
$(127,500)
27,000
52,500
11,050
23,500
c.
PVFactor
PV
1.0000 $(140,000)
3.1699
82,417
2.1651
108,255
0.8096
16,192
0.3855
3,855
$70,719
VC
$78,000
130,000
66,950
FC
$15,000
17,500
25,000
NetCashFlow
$27,000
52,500
11,050
PVFactor
PV
1.0000 $(127,500)
3.1699
85,587
2.1651
113,668
0.8096
8,946
0.3855
9,059
$89,760
Thebiggestfactorsaretheincreasedlevelofvariablecosts,
additionalworkingcapital,lowerinitialrevenues,andlowercostofproduction
equipment.
57. a.
Year
1
2
3
4
5
Cash
Receipts
$3,000,000
3,200,000
3,720,000
5,120,000
6,400,000
Cash
Expenses
$2,530,000
2,400,000
2,582,000
3,232,000
3,520,000
Net
Inflows
$470,000
800,000
1,138,000
1,888,000
2,880,000
Cumulative
CashFlows
$470,000
1,270,000
2,408,000
4,296,000
7,176,000
Payback=4+[($6,400,000$4,296,000)$2,880,000]=4.7years
b. Year
CashFlow
0
$(6,400,000)
1
470,000
2
800,000
3
1,138,000
4
1,888,000
5
2,880,000
6
2,880,000
7
1,632,000
8
648,000
NPV
PVFactor
1.0000
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0.5835
0.5403
PV
$(6,400,000)
435,173
685,840
903,344
1,387,680
1,960,128
1,814,976
952,272
350,114
$2,089,527
195
Chapter 15
c. Year
NetIncome
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
Averageannualincome=$5,936,0008=$742,000
Averageinvestment=(Cost+Salvage)2
=($6,400,000+$0)2=$3,200,000
ARR=$742,000$3,200,000=23.2%
d.
Although there are no stated evaluation criteria for

accounting rate of return or payback, the NPV criterion meets the standard
thresholdof$0.Therefore,theproductlineshouldbeadded.
58. a.Initialcost:t0=$(1,460,000)+$340,000=$(1,120,000)
Annualcashflow:
$264,000
Additionalrevenue($1.20220,000)
60,000
Laborsavings($160,000 $100,000)
Otheroperatingsavings($192,000$80,000)
112,000
Total
$436,000
NPV=$(1,120,000)+($436,0006.1446)=$1,559,046
b.
Discountfactor=$1,120,000$436,000=2.5688
TheIRRexceedsnumbersreportedinthepresentvalueappendix.Bycomputer,
theIRRisfoundtobe37percent.
c.
$1,120,000$436,000=2.6years
d.
ARR=($436,000$62,000)[($1,120,000+$0)2]=
66.8%
e.
BecausetheprojectgeneratesaveryhighNPVandIRR,as
wellasahighARR,thefirmshouldbuythenewlathe.
(CMAadapted)

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170

The profitability index (PI) is calculated by dividing the discounted cash

In capital budgeting, sensitivity analysis is used to

Postinvestment audits are performed to determine

The time value of money refers to the concept that

a. Investment = $140,000 + $180,000 = $320,000

Yes. Houston Fashions should also use a discounted cash flow

The equipment investment is acceptable. Note, because of the more rapid

In the future, the company could face not only

Hernandez should justify the investment based

Comparison of actual and projected results to validate that a project is

Although there are no stated evaluation criteria for

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