capital budgeting

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CAPITAL BUDGETING

The following tables are needed to complete problems requiring present value

computations. Students may also use a calculator or computer spreadsheet program, but the

answers to the multiple choice may change due to rounding errors.

to complete this problem.) when these tables are insufficient for completion.

Period 5% 10% 15% 20% Period 5% 10% 15% 20%

5 0.7835 0.6209 0.4972 0.4019 5 4.3295 3.7908 3.3522 2.9906

10 0.6139 0.3855 0.2472 0.1615 10 7.7217 6.1446 5.0188 4.1925

20 0.3769 0.1486 0.0611 0.0261 20 12.4622 8.5136 6.2593 4.8696

Period 5% 10% 15% 20% Period 5% 10% 15% 20%

5 1.2763 1.6105 2.0114 2.4883 5 0.2310 0.2638 0.2983 0.3344

10 1.6289 2.5937 4.0456 6.1917 10 0.1295 0.1627 0.1993 0.2385

20 2.6533 6.7275 16.3665 38.3376 20 0.0802 0.1175 0.1598 0.2054

TRUE/FALSE

a. True

b. False

2. Long-term asset acquisitions are evaluated to determine whether future benefits justify the

initial cost.

a. True

b. False

a. True

b. False

4. Robert wants to invest in a certificate of deposit that pays out $4,000 in four years. If

interest rates increase, the required initial investment will also increase.

a. True

b. False

5. The future value of $100 is greater than its present value.

a. True

b. False

a. True

b. False

a. True

b. False

8. The cost of capital reflects the degree of financial and operating risk to the organization.

a. True

b. False

9. If a companys cost of capital is 15%, a net present value of $10 indicates an acceptable

capital project.

a. True

b. False

10. Choosing the greatest net present value is always the best decision choice.

a. True

b. False

11. When using net present value and a 12% discount rate results in an acceptable project, then

a 9% discount rate will also result in that same project being acceptable.

a. True

b. False

12. The net present value method is considered superior to the internal rate of return for

evaluating capital projects.

a. True

b. False

13. The internal rate of return method assumes the organization can reinvest a projects

intermediate cash flows at the projects internal rate of return.

a. True

b. False

14. The payback method does not consider the time value of money and, therefore, is rarely

used in practice.

a. True

b. False

15. If a companys cost of capital is 12%, a net present value of $1 indicates the projects actual

rate of return exceeds 12%.

a. True

b. False

16. The profitability index provides comparison information for projects with different initial

investments.

a. True

b. False

17. Economic value added is best suited for evaluating new capital projects.

a. True

b. False

18. Depreciation reduces income and, therefore, helps reduce the income taxes of an

organization.

a. True

b. False

19. To account for inflation, discount the cash flow by the appropriate discount rate and the

expected inflation rate.

a. True

b. False

20. Capital budgeting estimates are usually more accurate for new projects.

a. True

b. False

21. If a capital project is projected to return less than the cost of capital, it may still be

implemented for strategic reasons.

a. True

b. False

22. Post-implementation audits help ensure planning groups use reasonable estimates.

a. True

b. False

MULTIPLE CHOICE

23. The purchase of long-term assets results in all of the following EXCEPT:

a. the creation of committed resources

b. the creation of unit-related costs

c. additional risk for the organization

d. reduced organizational flexibility

24. An organization must approach long-term investments cautiously because of all of the

following EXCEPT that:

a. the long-term nature creates technological risk

b. invested amounts are committed for an extended period of time

c. the value of money decreases with time

d. a large amount of capital is usually invested

Carol invests $10,000 in a 2-year certificate of deposit (CD) that will earn a 6% annual rate of

return compounded annually.

25. At the end of the two years, the future value of the CD is:

a. $10,000

b. $10,600

c. $11,200

d. $11,236

a. 6%

b. 12%

c. 12.36%

d. None of the above is correct.

27. The difference between the present value and the future value of this investment is:

a. the annuity of the investment

b. interest earned on the investment

c. the investment rate of return

d. the cash inflows from the investment

28. For the purchase of a boat, motor, and trailer, Steven needs to accumulate $25,000 at the

end of two years. His initial investment will earn 8% annual interest compounded

semiannually. For this investment:

a. the number of compounding periods is 2

b. the interest earned per compounding period is 4%

c. $25,000 is the present value

d. the rate of return is 16%

29. Investments A and B both have a future value of $5,000 and are exactly the same except

that Investment A has a 5% rate of return while Investment B has an 8% rate of return. The

present value of Investment A will be __________ the present value of Investment B.

a. less than

b. the same as

c. greater than

d. cant tell

30. Investments A and B both have a future value of $5,000 and are exactly the same except

that Investment A matures in 5 years while Investment B matures in ten years. The present

value of Investment A will be __________ the present value of Investment B.

a. less than

b. the same as

c. greater than

d. cant tell

31. A lottery pays the winner $100,000 per year for 20 years. The present value of this prize

money is:

a. greater than $2,000,000

b. $2,000,000

c. less than $2,000,000

d. indeterminable

a. reflects the perceived level of risk that investors require

b. is used to calculate the accounting rate of return

c. is used to calculate future value

d. is another term for the rate of return

An investor wants to have $25,000 in an account at the end of 25 years. At current interest rates,

$5,000 needs to be deposited now to reach the goal of $25,000.

a. $1,000

b. $5,000

c. $25,000

d. More information is needed to determine the amount.

34. Assume interest rates increase before the investment is made. To reach the same goal of

$25,000 in 25 years, the investor will have to deposit:

a. more than $5,000

b. $5,000

c. less than $5,000

d. More information is needed to determine the amount of the deposit.

35. You have been offered the following two annuities for the same price: Annuity 1 pays

$20,000 per year for 10 years; and Annuity 2 pays $40,000 per year for 5 years. Which of

these two annuities offers a greater value?

a. They are of equal value because both pay $200,000 over the life of the annuity.

b. Annuity 2 is of greater value because the payments are received sooner.

c. Annuity 1 is of greater current value because the payments are received over a longer

period of time.

d. The value cannot be determined without proper present value analysis.

A bond with a face value of $10,000 pays $600 in interest every six months for 10 years and a

lump sum of $10,000 at the end of the tenth year. The current market requires 10% interest

compounded semiannually.

36. What is the present value of the $10,000 payment at the end of the tenth year?

a. $ 1,486

b. $ 3,769

c. $ 3,855

d. $61,446

a. are an example of an annuity

b. have a present value of $12,000

c. reflect the actual rate of interest received by the investor

d. are all paid at time zero

38. What is the present value of the $600 semiannual interest payments?

a. $12,000

b. $3,687

c. $4,626

d. $7,477

39. What would an investor be willing to pay now for this $10,000 bond?

a. More than $10,000

b. $10,000

c. Less than $10,000

d. More information is needed to determine the amount.

40. All of the following use the time value of money to evaluate long-term investments

EXCEPT:

a. the payback method

b. the net present value method

c. the internal rate of return

d. the profitability index

41. Assume a capital project requires $42,000 as an initial investment and expects a net cash

inflow of $12,000 per year. The payback period method:

a. would consider the capital project acceptable if the company requires a minimum

payback period of three years

b. is usually used as a screening device to eliminate capital projects from further

investigation

c. uses accounting net income rather than cash flows in the calculations

d. compares the rate of return to the companys cost of capital

a. considers the time value of money

b. ignores cash outflows after the initial investment

c. incorporates the timing of cash flows

d. utilizes depreciation for the calculation of average income

43. The net present value (NPV) capital budgeting decision method:

a. can be directly compared between alternatives

b. incorporates the time value of money in the calculations

c. is based on accounting net income

d. indicates an acceptable capital project with a negative value

a. indicates the capital projects rate of return exceeds the companys cost of capital

b. for one project is considered superior to another project with a net present value of

$500

c. indicates the internal rate of return would be unacceptable

d. indicates cash inflows total $1,000 for the capital project

45. Project A: present value (PV) of the cash inflows is $55,000 and the PV of the cash

outflows is $50,000. Project B: PV of the cash inflows is $24,000 and the PV of the cash

outflows is $20,000. All of the following are true EXCEPT:

a. the net present value of Project A is $5,000

b. the net present value of Project B is $4,000

c. the profitability index for Project A is 1.1

d. Project A is a better investment than Project B

46. A 16% internal rate of return (IRR) indicates all of the following EXCEPT:

a. the actual rate of return of all cash inflows and outflows

b. that a 16% discount rate will result in the calculation of a net present value of zero

c. a better indication of acceptable capital projects when there is limited capital than the

net present value method

d. an acceptable capital project if the cost of capital is 12%

47. Which of the following indicates an UNACCEPTABLE capital project?

a. The internal rate of return exceeds the cost of capital.

b. The net present value of a project is 10.

c. The profitability index of a project is 0.97.

d. The accounting rate of return exceeds the target rate of return.

48. __________ is best for comparing mutually exclusive projects of different sizes.

a. The payback method

b. The net present value method

c. The internal rate of return

d. The profitability index

a. is most widely used to evaluate new capital investments

b. in practice is similar to net present value but it uses accounting income rather than

cash flows in the evaluation

c. determines the actual rate of return of all cash inflows and outflows

d. is similar to the internal rate of return but it corrects for the conservative bias

50. Hitz Corporation is financed 60% by debt with a pretax cost of 10%, and 40% by common

equity with a pretax cost of 15%. Hitz Corporations marginal tax rate is 50%. Hitzs

weighted average cost of capital is:

a. 9.0%

b. 10.0%

c. 12.0%

d. 12.5%

Crittenden Company is considering two mutually exclusive investments in capital equipment that

have a 10% cost of capital. Cash flow information for the two alternatives is below.

Investment 1 Investment 2

Initial investment in equipment $110,000 $170,000

Increase in annual cash flows $ 20,000 $ 30,000

Life of equipment 10 years 10 years

Salvage value of equipment 0 0

51. Determine the present value of the initial investment for each alternative.

a. $42,405 and $65,535

b. $675,906 and $1,044,582

c. $1,700,000 and $1,100,000

d. None of the above is correct.

52. Determine the present value of the annual cash flows for each alternative.

a. $7,710 and $11,565

b. $20,000 and $30,000

c. $122,892 and $184,338

d. $200,000 and $300,000

a. $12,892 and $14,338

b. $90,000 and $140,000

c. $67,591 and $104,465

d. None of the above is correct.

a. 0.895 and 0.922

b. 1.117 and 1.084

c. 5.500 and 5.667

d. None of the above is correct.

a. investment 1 because of the lower initial investment

b. investment 2 because of the greatest annual cash flows

c. investment 1 because of the greatest profitability index

d. investment 2 because of the greatest net present value

Consider the following two mutually exclusive projects, each of which requires an initial

investment of $30,000 and both provide cash inflows of $60,000 as shown below. This

organization has a 15% cost of capital.

Year Project A Project B

0 ($30,000) ($30,000)

1 $30,000 $10,000

2 20,000 20,000

3 10,000 30,000

56. Using the payback criterion, which is the most desirable project?

a. Project A

b. Project B

c. Both projects A and B are equally acceptable.

d. Neither project A or B is acceptable.

57. Using the net present value criterion, which is the most desirable project?

a. Project A

b. Project B

c. Both projects A and B are equally acceptable.

d. The desirability cannot be determined using the current information.

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 58 AND 59.

Davidson Company is now investigating three mutually exclusive investment opportunities. The

companys cost of capital is 10 percent. Information on the three investment projects under study

is given below:

----1---- ----2---- ----3----

Initial investment $(40,000) $(36,000) $(45,000)

Net present value $(2,024) $7,340 $7,297

Profitability index 0.95 1.20 1.10

Internal rate of return 8% 14% 19%

Life of the project 5 yrs 12 yrs 3 yrs

Davidson Company has limited funds available for investment and, therefore, it cant accept all

of the projects listed above.

58. Which projects are acceptable to Davidson?

a. investment 2

b. investment 3

c. investment 2 and 3

d. investment 1, 2, and 3

59. Which single investment do you recommend of these three mutually exclusive projects?

a. investment 1

b. investment 2

c. investment 3

d. All of these investments could be recommended.

During 2005, a franchise-owned restaurant averaged:

$300,000 in sales;

$50,000 in net cash flows; and

$30,000 in operating income.

The expected cash investment per franchise-owned restaurant opening in the year 2005 was

$250,000. Assume the value of the investment decreases to zero over a ten-year period of time.

a. 5.0 years

b. 8.4 years

c. 6.0 years

d. 10.0 years

61. The accounting rate of return for one franchise-owned restaurant is:

a. 0.12

b. 0.24

c. 0.10

d. 0.20

62. Assuming a 10 % required rate of return, the net present value for one franchise-owned

restaurant is:

a. $19,275

b. $11,565

c. ($65,662)

d. $57,230

a. 1.667

b. 0.737

c. 1.229

d. 0.813

64. The internal rate of return for one franchise-owned restaurant is:

a. approximately 15%

b. 10%

c. greater than 20%

d. The IRR cannot be determined.

a. No, because the payback period is too long.

b. No, because the expected net annual cash inflows are inadequate.

c. Yes, because the investment delivers more than the 10% required rate of return.

d. Yes, because the accounting rate of return is greater than 10%.

During 2005, a franchise-owned restaurant averaged:

$200,000 in sales;

$75,000 in net cash flows; and

$20,000 in operating income.

The expected cash investment per franchise-owned restaurant opening in the year 2005 was

$500,000. Assume the value of the investment decreases to zero over a ten-year period of time.

a. 6.67 years

b. 2.67 years

c. 3.75 years

d. 10.0 years

67. The accounting rate of return for one franchise-owned restaurant is:

a. 0.04

b. 0.08

c. 0.10

d. 0.40

68. Assuming a 10 % required rate of return, the net present value for one franchise-owned

restaurant is:

a. $7,710

b. $260,845

c. ($377,108)

d. ($39,155)

a. 2.304

b. 0.434

c. 0.922

d. 1.085

70. The internal rate of return for one franchise-owned restaurant is:

a. between 5% and 10%

b. 10%

c. greater than 20%

d. The IRR cannot be determined

a. Yes, because the payback period is less than ten years.

b. Yes, because the expected net annual cash inflows provide a good salary.

c. No, because the investment delivers less than the 10% required rate of return.

d. No, because the accounting rate of return is less than 10%.

a. are increased as a result of depreciation

b. affect lump-sum payments but not annuities

c. can best be analyzed by using pretax cash flows

d. usually increase when the net benefit of an investment increases

73. All of the following are true regarding capital budgeting EXCEPT that:

a. estimates are not always realized

b. estimating future cash flows is relatively easy

c. most estimates are extended projections of past cash flow information

d. estimating circumstances not previously experienced is the hardest

a. the effects of a change in a parameter on a decision

b. if the project is too risky to undertake

c. the effect of adding or dropping a product line

d. which planners make poor estimates

75. Strategic considerations:

a. are fairly easy to determine

b. evaluate a firms competitive edge

c. should not override capital budgeting analysis results

d. are decreasing in importance

a. are useful to identify how future estimates can be improved

b. help ensure planning estimates are reasonable

c. are required by a companys external auditors

d. are conducted after a project has been implemented

REMINDER!!! Present value tables that are needed to answer the multiple choice

questions are located at the beginning of this chapter.

EXERCISE/PROBLEM

77. An investor wants to have $20,000 in an account at the end of 20 years. At current interest

rates, $7,000 needs to be deposited now to reach the goal of $20,000.

a. What is the present value of this investment?

b. Assume interest rates decrease before the investment is made. Will an investment of

$7,000 still result in $20,000 in 20 years? Why or why not?

78. You have been offered the following two annuities for the same price: Annuity 1 pays

$50,000 per year for 10 years; and Annuity 2 pays $25,000 per year for 20 years. Which of

these two annuities is a better deal? Why?

79. A lottery pays the winner $50,000 per year for 20 years.

a. Is the winner receiving a $1,000,000 value? Why or why not?

b. Is the winner receiving an annuity? How can you tell?

c. Compute the present value of the prize money assuming a 5% discount rate. Explain

what this amount indicates.

80. A bond with a face value of $25,000 pays $1,000 in interest every six months for 10 years

and a lump sum of $25,000 at the end of the tenth year. The current market requires 10%

interest compounded semiannually.

a. What would an investor be willing to pay now for

1. the $25,000 at the end of the tenth year?

2. the $1,000 semiannual interest payments?

3. the $25,000 bond?

b. Is this bond selling at a premium or a discount? Why?

81. Hitz Corporation is financed 70% by debt with a pretax cost of 10%, and 30% by common

equity with a pretax cost of 18%. Hitz Corporations marginal tax rate is 40%.

a. Calculate Hitzs weighted average cost of capital.

b. How might the cost of capital be used for decision making at Hitz Corporation?

82. Crittenden Company is considering two mutually exclusive investments in capital

equipment that have a 10% cost of capital. Cash flow information for the two alternatives is

below.

Investment 1 Investment 2

Initial investment in equipment $210,000 $135,000

Increase in annual cash flows $ 60,000 $ 40,000

Life of equipment 5 years 5 years

Salvage value of equipment 0 0

a. Determine the present value of the initial investment for each alternative.

b. Determine the present value of the annual cash flows for each alternative.

c. Compute the net present value for each investment.

d. Compute the profitability index for each investment.

e. Which investment would you recommend? Why?

83. Stevens Company is contemplating the purchase of a corporate jet. This jet could be either

purchased or rented from the manufacturer. The length of the purchase contract is five

years. If the jet is purchased, Stevens could sell it at the end of five years for $600,000. The

companys cost of capital is 20%. The data concerning these two alternatives are as

follows:

Purchase Rent

Purchase price $820,000 --

Annual cash payments for servicing and licenses 40,000 --

Depreciation each year 44,000 --

Salvage value at the end of year 5 600,000 --

Estimated annual rental payments -- $250,000

b. Which is the better alternative? Why?

which would create a net cash inflow of $40,000 for five years. The companys cost of

capital is 10% and the tax rate is 40%.

Increase in annual cash flows $40,000

Life of equipment 5 years

Salvage value of equipment 0

a. Assuming the company uses straight-line depreciation for tax purposes, what is the

net present value of purchasing the new equipment, taking income taxes into account?

b. Should Roberts consider this purchase? Why or why not?

85. Consider the following two mutually exclusive projects, each of which require an initial

investment of $100,000 and have no salvage value. This organization, which has a cost of

capital of 15%, must choose one or the other.

1 $10,000 $50,000

2 20,000 40,000

3 30,000 30,000

4 40,000 20,000

5 50,000 10,000

a. Compute the payback period of these two projects. Using the payback criterion,

which project is more desirable?

b. What are the advantages and drawbacks of using the payback period criterion to select

a capital investment alternative?

c. Straight-line depreciation is used to compute income. Compute the accounting rate of

return for these two projects. Using the accounting rate of return criterion, which

project is more desirable?

d. What are the advantages and drawbacks of using the accounting rate of return

criterion to select a capital investment alternative?

e. Which is the better investment? Why?

86. Davidson Company is now investigating five different investment opportunities. The

companys cost of capital is 10 percent. Information on the five investment projects under

study is given below:

----1---- ----2---- ----3---- ----4---- ----5----

Initial investment $(48,000) $(36,000) $(27,000) $(45,000) $(40,000)

Present value of cash inflows

at a 10% discount rate 56,727 43,340 33,614 52,297 37,976

Internal rate of return 16% 14% 18% 19% 8%

Life of the project 6 yrs 12 yrs 6 yrs 3 yrs 5 yrs

Davidson Company has limited funds available for investment and, therefore, cant accept

all of the projects listed above.

b. Compute the profitability index for each investment project.

c. Which projects are acceptable to Davidson? Why?

d. Rank the five projects according to preference in terms of:

1. net present value;

2. profitability index; and

3. internal rate of return.

e. Which investment do you recommend? Why?

87. (Additional PV information is needed to complete this problem.) Papa Johns International,

Inc., has surpassed Little Caesars to become the Number 3 pizza chain, behind Pizza Hut

and Domino's, with more than 2,300 restaurants scattered across the U.S. and five other

countries. Most restaurants offer delivery or take-out only.

The following information was reported by Papa Johns on the Form 10-K for the fiscal

year ended December 26, 1999: For a company-owned restaurant average sales were

$754,000; average cash flows were $154,000; and average operating income was $128,000.

The expected cash investment per company-owned restaurant opening in the year 2000 is

$244,000. Assume the value of the investment decreases to zero over a ten-year period of

time.

a. payback period;

b. accounting rate of return;

c. net present value assuming a 16% required rate of return; and

d. internal rate of return.

or why not?

Truro Winery is considering the following investment opportunity in a new machine to

make Golden Glow, its new apple cider. The investment required is $14,000,000 at the

start of year 1 and $10,000,000 at the start of year 2. Starting at the end of year 2, the

machine will provide incremental cash inflows of $8,000,000 per year for 12 years. The

annual operating expenses associated with the machine will be $3,000,000 each year. If the

Truro Winery's after-tax cost of capital is 12% and its marginal tax rate is 30%, compute

the following:

a. payback;

b. accounting rate of return (assuming straight-line depreciation);

c. net present value; and

d. internal rate of return.

CRITICAL THINKING/ESSAY

89. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate

investments in long-term assets. Why do these assets deserve this attention?

90. Some people believe that discounted cash flow analysis discriminates against long-term

projects because it heavily penalizes cash flows that occur well into the future. Comment.

91. Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%

discount rate to evaluate capital project XYZ?

92. Explain the profitability index and the payback methods used in capital budgeting. Discuss

when it would be most appropriate to use each.

93. List two capital budgeting methods that utilize the time value of money and explain how

each ranks the performance of different alternatives.

94. Explain how the internal rate of return criterion, if improperly applied, can cause managers

to make inappropriate investment decisions.

95. You are considering an investment in a new restaurant chain. You have developed

estimates of the initial investment required and the cash flows from that investment.

However, you are wondering about the risk of your investment. How might you assess the

impact of estimates in your investment decision?

organization's planners expect that this training program, which would cost $5,000,000,

will reduce manufacturing costs and increase the quality of the company's various products.

How would you frame this decision in the capital budgeting context?

97. An organization's planners have received a proposal from a manufacturing group to invest

in a new production line. The planners are suspicious that the proposal reflects the group's

interest in acquiring the latest technology rather than reflecting sound economic evaluation.

How might the planners deal with this situation?

98. Officials at Dundas Manufacturing have just completed a post-implementation audit of a

distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group

had proposed the warehouse investment arguing that it would improve sales by increasing

product quality and improving customer service. The expected rate of return on this

investment was 18%, however, the actual return on this investment to date has fallen far

below this estimate and it is even below the company's cost of capital of 11%. The post-

implementation audit concluded that the managers proposing this investment were

ambitious, to the point of being reckless, in making the estimates underlying the project's

proposals and argued that the investment should never have been made.

In response, the two managers who proposed the project argue that the proposal was a good

one based on estimates that seemed sound at the time. However, several uncontrollable

events, including the entry of a new competitor into the market, caused results to be lower

than expected. Moreover, the two managers argue that results would have been even worse

for the company if the investment had not been made. How would you deal with this

situation?

CHAPTER 11 SOLUTIONS

CAPITAL BUDGETING

LO3 2. a LO2 24. c LO4 52. c

LO3 3. b LO3 25. d LO4 53. a

LO3 4. b LO4 54. b

LO3 5. a LO3 26. a LO4 55. c

LO3 27. b

LO3 6. b LO3 28. b LO4 56. a

LO3 7. b LO3 29. c LO4 57. a

LO3 8. a LO3 30. c LO4 58. c

LO4 9. a LO4 59. b

LO4 10. b LO3 31. c LO4 60. a

LO3 32. a

LO4 11. b LO3 33. b LO4 61. b

LO4 12. a LO3 34. c LO4 62. d

LO4 13. a LO3 35. b LO4 63. c

LO4 14. b LO4 64. a

LO4 15. a LO3 36. b LO4 65. c

LO3 37. a

LO4 16. a LO3 38. d LO4 66. a

LO4 17. b LO3 39. a LO4 67. b

LO5 18. a LO4 40. a LO4 68. d

LO5 19. a LO4 69. c

LO6 20. b LO4 41. b LO4 70. a

LO4 42. d

LO7 21. a LO4 43. b LO4 71. c

LO8 22. a LO4 44. a LO5 72. d

LO4 45. d LO6 73. b

LO6 74. a

LO4 46. c LO7 75. b

LO4 47. c

LO4 48. d LO8 76. c

LO4 49. b

LO4 50. a

MULTIPLE CHOICE

36. $10,000 x PVF (5%, 20 periods) 0.3769 = $3,769

38. $600 x PVF Annuity (5%, 20 periods) 12.4622 = $7,477

45. The profitability index of Project B $24,000 / $20,000 = 1.20, which is greater than the

profitability index of Project A at $55,000 / $50,000 = 1.10

Debt 10% (1-tax rate) 5% 60% 3.0%

Common equity 15% 15% 40% 6.0%

Weighted average cost of capital 9.0%

52. $20,000 x PVF Annuity (10%, 10 periods) 6.1446 = $122,892

$30,000 x PVF Annuity (10%, 10 periods) 6.1446 = $184,338

53. $20,000 x PVF Annuity (10%, 10 periods) 6.1446 = $122,892 - $110,000 = $12,892

$30,000 x PVF Annuity (10%, 10 periods) 6.1446 = $184,338 - $170,000 = $14,338

54. $122,892 / $110,000 = 1.117; $184,338 / $170,000 = 1.084

56. Payback is one year for Project A and two years for Project B

57. Because Project A receives more cash sooner, the net present value will be greater.

58. Investments 2 and 3 report positive net present values, which indicates the return is greater

than the required cost of capital

59. Investment 2 because it offers a 14% return over four years, and therefore, the profitability

index of 1.20 is the greatest.

60. $250,000 amount invested / $50,000 expected annual net cash inflow = 5.0 payback period

61. $30,000 average annual operating income from asset / [($250,000 + 0) / 2] average amount

invested in assets = 0.24 accounting rate of return

62. PV of annuity (10-year, 10%) $50,000 x 6.1446 = ...........$307,230

Investment ......................................................................... (250,000)

Net present value...............................................................$ 57,230

63. $307,230 / #250,000 = 1.229

64. $250,000 investment / $50,000 expected annual net cash inflow = 5.0 PV annuity factor.

PV annuity factor for (10-year, 15%) = 5.0188, therefore IRR is approximately 15%.

66. $500,000 amount invested / $75,000 expected annual net cash inflow = 6.67 payback

period

67. $20,000 average annual operating income from asset / [($500,000 + 0) / 2] average amount

invested in assets = 0.08 accounting rate of return

68. PV of annuity (10 years, 10%) $75,000 x 6.1446 = ..........$460,845

Investment ......................................................................... (500,000)

Net present value.............................................................. $ (39,155)

69. $460,845 / $500,000 = 0.922

70. $500,000 investment / $75,000 expected annual net cash inflow = 6.67 PV annuity factor.

PV annuity factor for (10-year, 10%) = 6.1446 and PV annuity factor for (10-year, 5%) =

7.7217. Therefore, the IRR is between 5% and 10%.

EXERCISE/PROBLEM

LO3

77. a. The present value is $7,000.

b. No, an investment of $7,000 will no longer result in $20,000 in 20 years. Due to the

lower interest rates, less interest will be earned over the 20 years, therefore, the initial

investment now needs to be greater than $7,000. PV + interest earned = FV.

LO3

78. Even though both annuities pay $500,000 in total, Annuity 1 is the better deal because the

total payback of $500,000 is received 10 years earlier.

LO3

79. a. No, the lottery winner is not receiving a $1,000,000 value because the entire sum is

not being received now. Because money can earn a return, its value depends on when

it is received.

b. Yes, this is an annuity because the winner is receiving the same amount at the end of

each year for 20 years.

c. The present value of the prize money is $623,110 = ($50,000 x 12.4622). This

indicates that the 20 payments of $50,000 each to be received in the future are only

worth $623,110 now, rather than $1,000,000.

LO3

80. a1. Present value of the $25,000 at the end of ten years is $9,423 = $25,000 x 0.3769.

a2. Present value of the $1,000 semiannual interest payments is $12,462 = $1,000 x

12.4622.

a3. Present value of the $25,000 bond is $21,885 = ($9,423 + $12,462).

b. This bond is selling at a discount because the bond is only paying 8% ($2,000 per year

/ $25,000 face) interest when the market rate is 10%. To achieve the higher yield, the

investor pays in less than face value (discounted), but at maturity the investor receives

the full $25,000 face value.

LO3

81. a. Pretax cost After tax cost Weight Weighted average

Debt 10% (1-tax rate) 6% 70% 4.2%

Common equity 18% 18% 30% 5.4%

Weighted average cost of capital 9.6%

b. Hitz Corporation may use the cost of capital as a benchmark for accepting or rejecting

capital investment proposals.

LO4

82. Investment 1 Investment 2

a. PV of the initial investment

$210,000 $135,000

b. PV of the annual cash flows

$227,448 = ($60,000 x 3.7908) $151,632 = ($40,000 x 3.7908)

c. Net present value $17,448 = ($227,448 $210,000) $16,632 = ($151,632 $135,000)

d. Profitability index 1.083 = ($227,448 / $210,000) 1.123 = ($151,632 / $135,000)

e. The profitability index indicates that Investment 2 is preferred, while the net present

value method does not inherently distinguish between projects with different

magnitudes of initial investment. However, the final choice between these two

mutually exclusive alternatives may depend on qualitative factors that distinguish

between the two alternatives or identify other possible uses for the available funds.

LO4

83.

a. Purchase the Jet Rent the Jet

Item Amount Yrs PV@ 20% Item Amount Yrs PV@ 20%

Purchase (820,000) now (820,000) Rent (250,000) 1-5 (747,650)

Services (40,000) 1-5 (119,624)

Salvage 600,000 5 241,140

(698,484) *Depreciation is not a cash flow.

b. Net present value indicates that purchasing the jet is the preferred alternative. However,

even though the net present values differ by $49,166, the additional risk of ownership may

sway the company to choose to rent on a use-by-use basis.

LO5

84. a. The net present value is $45,691 when income taxes are taken into account.

Annual cash flow Depreciation Taxable income Tax @ 40% Net cash flow

$40,000 $13,000 $27,000 $10,800 $29,200

Initial investment ($65,000)

Annual cash flows $29,200 3.7908 (5yrs, 10%) 110,691

Net present value ($45,691)

b. Yes, Roberts should consider this purchase because the net present value is positive,

which indicates the purchase meets the companys 10% cost of capital requirement.

LO4

85. a. Project A payback period is 4 years.

Project B payback period is 2.33 years = (2 years + $10,000/$30,000)

The payback criterion indicates that Project B is the preferred investment because it

has the shorter payback period.

b. The advantage of using the payback period criterion is that it gives an indication of

the projects risk, in the sense that the longer the payback period, the longer an

organization is exposed to an unrecovered investment. Drawbacks include that it

ignores the time value of money and that it ignores cash outflows after the initial

investment and cash inflows after the payback period.

average investment).

Average increase in income is [(10+20+30+40+50) / 5] = $30,000 per year

Depreciation is $100,000 / 5 years = $20,000 per year

* Average income is $10,000 = (Average increase $30,000 Depreciation $20,000)

** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]

average investment).

Average increase in income is [(50+40+30+20+10) / 5] = $30,000 per year

Depreciation is $100,000 / 5 years = $20,000 per year

* Average income is $10,000 = (Average increase $30,000 Depreciation $20,000)

** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]

The accounting rate of return criterion indicates both projects are equally attractive.

income rather than cash flows for all periods. Disadvantages include not considering

the time value of money and not explicitly considering the timing of cash flows.

LO4

86. a. ----1---- ----2---- ----3---- ----4---- ----5----

Present value of cash inflows

at a 10% discount rate $56,727 $43,340 $33,614 $52,297 $37,976

Initial investment (48,000) (36,000) (27,000) (45,000) (40,000)

Net present value $ 8,727 $ 7,340 $ 6,614 $ 7,297 $ (2,024)

b. Profitability index

-------1------- -------2------- -------3------ -------4------- -------5-------

1.18 = 56,727 1.20 = 43,340 1.24 = 33,614 1.16 = 52,297 0.95 = 37,976

48,000 36,000 27,000 45,000 40,000

acceptable because the project does meet the cost of capital requirement of 10%. This

is pointed out with the negative net present value, the profitability index that is below

1, and the 8% internal rate of return.

d. 1. Net present value is unable to rank projects with different initial investments.

2. Profitability ranking from highest to lowest is 3 2 1 4 5

3. Internal rate of return ranking from highest to lowest is 4 3 1 2 5

e. The profitability index indicates that Investment 3 is preferred, the internal rate of

return indicates that Investment 4 is preferred, while the net present value method

does not inherently distinguish between projects with different magnitudes of

investment. However, because the profitability index is considered superior to the

internal rate of return, I would recommend Investment 3. The final choice may depend

on qualitative factors that distinguish the four alternatives.

LO4

87. (Additional PV information is needed to complete this problem.)

a. Payback period is 1.58 years = $244,000 amount invested .

$154,000 expected annual net cash inflow

b. Accounting rate of return is 1.05 = $128,000 average annual operating income from asset

[($244,000 + 0) / 2] average amount invested in asset

c. Present value of annuity of equal net cash inflows for ten years assuming a 16% required

rate of return $154,000 x 4.833 = .............$744,282

Investment ...................................................... (244,000)

Net present value.........................................$500,282

$154,000 expected annual net cash inflow

A 1.58 annuity PV factor indicates an Internal rate of return of more than 50% for a ten-

year investment.

e. Yes, a Papa Johns company-owned restaurant appears to be a good investment because the

average payback period is less than two years, the average annual accounting rate of return

is over 100%, the investment more than delivers the 16% required rate of return, and the

internal rate of return is over 50%.

LO4

88. (Additional PV information is needed to complete this problem.)

a. The total initial investment, over the two years, is $24,000,000. The after-tax cash

flows, as shown in the following exhibits are $4,100,000 per year. Therefore, the

payback period, after the two-year initial investment period, is 5.85 years

($24,000,000/$4,100,000).

b. The initial investment is $24,000,000 and there is no salvage value. Therefore, the

average investment is $12,000,000 ($24,000,000/2). The machine has a 12-year life,

therefore the annual depreciation is $2,000,000. The annual taxes are $900,000 as

showing in the following exhibits. Thus, the annual after-tax accounting income is

$2,100,000 ($5,000,000 - $2,000,000 - $900,000). As a result, the accounting rate of

return is 17.5% ($2,100,000/$12,000,000).

c. The net present value of this investment is ($252,737), as shown in the following

exhibits.

d. The internal rate of return of this investment is approximately 11.8%, as shown in the

following exhibits.

EXHIBIT 1 Operating Taxable

Period Investments Cash Flows Depreciation Income

0 (14,000,000)

1 (10,000,000)

2 5,000,000 2,000,000 3,000,000

3 5,000,000 2,000,000 3,000,000

4 5,000,000 2,000,000 3,000,000

5 5,000,000 2,000,000 3,000,000

6 5,000,000 2,000,000 3,000,000

7 5,000,000 2,000,000 3,000,000

8 5,000,000 2,000,000 3,000,000

9 5,000,000 2,000,000 3,000,000

10 5,000,000 2,000,000 3,000,000

11 5,000,000 2,000,000 3,000,000

12 5,000,000 2,000,000 3,000,000

13 5,000,000 2,000,000 3,000,000

Period Taxes Cash Flows @ 12% @ 11.8%

0 (14,000,000) (14,000,000) (14,000,000)

1 (10,000,000) (8,928,571) (8,944,544)

2 900,000 4,100,000 3,268,495 3,280,199

3 900,000 4,100,000 2,918,299 2,933,989

4 900,000 4,100,000 2,605,624 2,624,319

5 900,000 4,100,000 2,326,450 2,347,334

6 900,000 4,100,000 2,077,188 2,099,583

7 900,000 4,100,000 1,854,632 1,877,981

8 900,000 4,100,000 1,655,921 1,679,768

9 900,000 4,100,000 1,478,501 1,502,476

10 900,000 4,100,000 1,320,090 1,343,896

11 900,000 4,100,000 1,178,652 1,202,054

12 900,000 4,100,000 1,052,368 1,075,183

13 900,000 4,100,000 939,614 961,702

(252,737) (16,059)

CRITICAL THINKING/ESSAY

LO1

89. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate

investments in long-term assets. Why do these assets deserve this attention?

Solution: Long-term assets commit the organization to a technology or a process for long

periods of time, creating a technological risk for the organization, and they can usually only

be reversed at great cost. The investment in long-term assets is usually the largest that an

organization makes, creating financial risk for the organization.

LO3

90. Some people believe that discounted cash flow analysis discriminates against long-term

projects because it heavily penalizes cash flows that occur well into the future. Comment.

Solution: Discounted cash flow analysis penalizes cash flows that occur into the future to

recognize the time value of money. For example, with a discount rate of 10%, a cash flow

received 10 years from now is discounted to about 39% of its future value. This is a big

penalty, however, it recognizes the time value of money and the real effect of investing in

long-term assets.

LO4

91. Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%

discount rate to evaluate capital project XYZ?

Solution: The discount rate is adjusted for the level of risk involved with the project. The

higher the discount rate used, the higher the level of risk for the project.

LO4

92. Explain the profitability index and the payback methods used in capital budgeting. Discuss

when it would be most appropriate to use each.

Solution: The profitability index compares the present value of all future cash inflows with

the present value of all future cash outflows. The discount rate allows for various amounts

of risk. This is the most comprehensive capital budgeting analysis tool and it is used to

evaluate the acceptability of a project and to rank projects.

The payback method uses the time to recover the initial investment as a measure of risk. It

is easy to use but because this method does not utilize the time value of money, its use is

usually limited to screening out unacceptable projects.

LO4

93. List two capital budgeting methods that utilize the time value of money and explain how

each ranks the performance of different alternatives.

Solution: Two capital budgeting methods that utilize the time value of money are the net

present value (NPV) method and the internal rate of return (IRR) method. The profitability

index is used to rank the performance of capital projects evaluated using the NPV method.

The IRR percentages can be used to rank the performance.

LO4

94. Explain how the internal rate of return criterion, if improperly applied, can cause managers

to make inappropriate investment decisions.

Solution: Suppose that an organization's cost of capital is 12% and that a decision maker

has been told that she will be rewarded based on the return on investment of the assets

under her control. The manager will be motivated to make return on investment as high as

possible. Therefore, investments that provide a return on investment that is lower than the

current average will be rejected, even though they may exceed the organization's cost of

capital. The problem with return on investment is that it is improperly used for motivational

purposes.

LO6

95. You are considering an investment in a new restaurant chain. You have developed

estimates of the initial investment required and the cash flows from that investment.

However, you are wondering about the risk of your investment. How might you assess the

impact of estimates in your investment decision?

Solution: One approach is to use sensitivity analysis. In this approach, the investor would

vary the cash flow estimates to identify how sensitive the decision to invest is to the

estimated cash flows. If the decision is very sensitive, that is, a 5-10% decrease in cash

flows would shift the investment decision from positive to negative, then the investor might

want to take steps to improve the reliability of the forecasts or not invest in the project.

LO7

96. An organization is considering investing in an employee-training program. The

organization's planners expect that this training program, which would cost $5,000,000,

will reduce manufacturing costs and increase the quality of the company's various products.

How would you frame this decision in the capital budgeting context?

Solution: If this project is to be evaluated using a capital budgeting tool, the organization

will have to quantify the expected benefits of the training program. This may be difficult to

do and, because of this, many organizations make investments like this as an act of faith

that the benefits will exceed the costs.

LO8

97. An organization's planners have received a proposal from a manufacturing group to invest

in a new production line. The planners are suspicious that the proposal reflects the group's

interest in acquiring the latest technology rather than reflecting sound economic evaluation.

How might the planners deal with this situation?

Solution: A common tool is to inform people proposing capital investments that the

organization will perform post-implementation audits on all investment projects to identify

whether benefits were as claimed and, if not, why not. Because this imposes risk on the

people who propose projects, post-implementation audits dampen enthusiasm for all project

proposals, not simply those that reflect non-economic considerations. Therefore, the

organization must make it clear that the post-implementation audits will try to ensure that

the audits are undertaken fairly with due consideration of events that would have been

unforeseeable when the project was proposed.

LO8

98. Officials at Dundas Manufacturing have just completed a post-implementation audit of a

distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group

had proposed the warehouse investment arguing that it would improve sales by increasing

product quality and improving customer service. The expected rate of return on this

investment was 18%, however, the actual return on this investment to date has fallen far

below this estimate and it is even below the company's cost of capital of 11%. The post-

implementation audit concluded that the managers proposing this investment were

ambitious, to the point of being reckless, in making the estimates underlying the project's

proposals and argued that the investment should never have been made.

In response, the two managers who proposed the project argue that the proposal was a good

one based on estimates that seemed sound at the time. However, several uncontrollable

events, including the entry of a new competitor into the market, caused results to be lower

than expected. Moreover, the two managers argue that results would have been even worse

for the company if the investment had not been made. How would you deal with this

situation?

Solution: This situation reflects the critical issue in interpreting a situation where events

were not as expected. The argument hinges on two things. First, it is unreasonable to

expect managers to be responsible for things beyond their control -- what is often called the

controllability principle in management accounting. Second, the events that occurred in

this situation were beyond the managers' control.

Many people believe that the controllability principle is fundamental because it appeals to a

common sense of fairness, namely that people should only be held accountable for what

they do or control. However, some people have argued that making people accountable for

whatever happens motivates them to search for ways to gain control over their

environment. Therefore, while rejecting the controllability principle at first seems harsh

and conflicting with a common view of equity, there may be good behavioral reasons for

doing this.

However, for the sake of discussion here, let us assume that the controllability principle is

applied. There are two issues in this case: first, whether or not these managers should

reasonably have anticipated the arrival of the new competitors and second, what would the

results of the new competitor have been if the organization had not built the new

warehouse. These issues are problematic and would have to be resolved by reference to the

facts in the particular situation including what other competitors were doing, public

announcements by the competitor, and what analysts who were following this market were

writing and saying.

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