# Solution Manual Cost and Managerial Accounting 3rd by BarfieldCapital Budgeting

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(2) 370 Chapter 14 Capital Budgeting 7. The time value of money is important because having a sum of money now allows a company to earn a return on it; if the same amount were not received until some time in the future, a return could not be earned on it between now and the time it is received. All else being equal, managers prefer to have cash receipts now rather than in the future and would prefer to make cash disbursements in the future rather than now. Future values can be converted into equivalent present values by the process of discounting. The following methods use the time value of money concept: net present value, internal rate of return, and the profitability index. The accounting rate of return and payback period do not use the time value of money concept. 8. Return of capital means the investor is receiving the principal that was originally invested. Return on capital means the investor is receiving an amount earned on the investment. 9. The NPV of a project is the present value of all cash inflows less the present values of all outflows associated with a project. If the NPV is zero, it is acceptable because, in that case, the project will exactly earn the required cost of capital rate of return. Also, when NPV equals zero, the project’s internal rate of return equals the cost of capital. 10. 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, the discount rate chosen and the timing and amounts of cash inflows and outflows. The original investment may also include an estimate of the amount of working capital that is needed at the beginning of the project life. 11. The NPV method subtracts the initial investment from the discounted net cash inflows to arrive at the net present value. The PI divides the discounted cash inflows by the initial investment to arrive at the profitability index. Thus, each computation uses the same set of amounts in different ways. The PI model attempts to measure the planned efficiency of the use of the money (i.e., output/input) in that it reflects the expected dollars of discounted cash inflows per dollar of investment in the project. 12. The PI will exceed 1 only in instances where the net present value exceeds 0. This is because the NPV is positive only if the present value of cash inflows exceeds the present value of cash outflows. Similarly, the present value of cash inflows

(3) Chapter 14 Capital Budgeting must exceed the present value of cash outflows if the numerator of the PI formula is to exceed the denominator. 371

(4) 372 Chapter 14 Capital Budgeting 13. 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 exceeds the company's cost of capital. 14. On any prospective project, when the NPV exceeds zero, the project's IRR will exceed the firm's discount rate that was used to find the NPV. If the IRR equals the firm's discount rate, the NPV will equal zero. If the IRR is less than the firm's discount rate, the NPV will be negative. This relationship holds true because, ultimately, under either method the calculations for project selection are designed to hinge on the project's cash flows in relation to the firm's discount rate. 15. 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. 16. The tax shield is the amount of revenue on which the depreciation prevents taxation. The tax benefit is the tax that is saved because of the depreciation and is found by multiplying the company's tax rate by the tax shield provided by depreciation. 17. 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? 18. NPV: Ranks projects in descending order of magnitude. PI: Ranks projects in descending order of magnitude if a positive cash flow project. IRR: Ranks projects in descending order of magnitude. Payback: Ranks projects in ascending order of magnitude. ARR: Ranks projects in descending order of magnitude. 19. Several techniques should be used because each technique provides valuable and different information. Of preferred use as the primary evaluator is the net present value in conjunction with the present value index, because management's goal should be to maximize, within budget and risk constraints, the net present value of the firm.

(5) Chapter 14 Capital Budgeting 373 20. Capital rationing exists because a firm often finds that it has the opportunity to invest in more acceptable projects than it has money available. Projects are first screened as to desirability and then ranked as to impact on company objectives. 21. 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 in capital budgeting analysis, the NPV of a project is lowered. 22. 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. 23. Postinvestment audits are performed for two reasons: to obtain feedback on past projects and to make certain that the champions of proposed projects submit realistic numbers knowing their estimates will ultimately be compared to actual numbers. These audits can provide information to correct problems and to assess how well the capital investment selection process is working. The larger the capital expenditure, the more important it is to perform postinvestment audits. Postinvestment audits are performed at the completion of a project. 24. The time value of money refers to the concept that money has time-based earnings power. Money can be loaned or invested to earn an expected 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 resulting in smaller present values. 25. An annuity is a cash flow that is repeated in successive periods. Single cash flows occur only in one period.

(6) Chapter 14 Capital Budgeting 374 26. 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. Exercises 27. a. 3 b. 10 c. 2 d. 9 e. 5 f. 8 g. 6 h. 4 i. 1 j. 7 28. a. b. c. d. e. f. g. h. i. j. 29. a. b. 9 4 7 3 6 5 10 2 8 1 Payback = $750,000 ÷ $150,000 per year = 5.00 years Year 1 2 3 4 5 6 7 8 9 Amount $ 75,000 75,000 75,000 75,000 75,000 100,000 100,000 100,000 100,000 Cumulative Amount $ 75,000 150,000 225,000 300,000 375,000 475,000 575,000 675,000 775,000 Payback = 8 + ($75,000 ÷ $100,000) years = 8.75 years, or 8 years and 9 months

(7) Chapter 14 Capital Budgeting 30. a. Year 1 2 3 4 5 6 7 Amount $ 5,000 9,000 16,000 18,000 15,000 14,000 12,000 375 Cumulative Amount $ 5,000 14,000 30,000 48,000 63,000 77,000 89,000 Payback = 4 years + ($12,000 ÷ $15,000) = 4.8 years b. 31. Yes. Bach’s 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. Point in time 0 1 2 3 4 5 6 7 8 9 10 Cash flows $(400,000) 70,000 70,000 85,000 85,000 85,000 86,400 86,400 86,400 62,000 62,000 NPV PV Factor 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4524 0.4039 0.3606 0.3220 Present Value $(400,000) 62,503 55,804 60,503 54,018 48,229 43,770 39,087 34,897 22,357 19,964 $ 41,132 Based on the NPV, this is an acceptable investment. 32. a. The contribution margin of each part is $28 ($50 - $22) Contribution margin per year = $28 × 50,000 = $1,400,000 Point in time Cash flows 0 $ (500,000) 1 - 8 (40,000) 1 - 8 1,400,000 NPV b. PV factor 1.0000 5.7466 5.7466 Present Value $ (500,000) (229,864) 8,045,240 $7,315,376 Based on the NPV, this is a very acceptable investment.

(8) Chapter 14 Capital Budgeting 376 c. Other considerations would include whether the company has the necessary capacity to produce the additional output, the possibility that the customer would decide to purchase elsewhere or would no longer have need for the parts after Machado Industrial has made its investment, and whether the company has considered all of the costs that would be affected by the decision to produce the new part—especially labor and overhead. 33. PI = PV of cash inflows PC of cash outflows = ($6,000 + $30,000) $30,000 = 1.20 34. a. PV of inflows $590,489 ($88,000 6.7101) PV of investment $500,000 PI = $590,489 ÷ $500,000 = 1.18 b. The OTA should accept the project because its PI is greater than 1.00. c. To be acceptable, a project must generate a PI of at least 1. a. PV = discount factor annual cash inflow $140,000 = discount factor $28,180 Discount factor = $140,000 ÷ $28,180 = 4.968 The IRR is 12% b. Yes. The IRR on this proposal is greater than the firm's hurdle rate of 10%. c. $140,000 = 5.335 Cash flow Cash flow = $26,242 a. Year Amount Cumulative Amount 1 $14,000 $ 14,000 2 14,000 28,000 3 11,000 39,000 4 11,000 50,000 Payback = 4 years + (52,000 - 50,000) $9,000 = 4.22 years b. Point in time 0 1 - 2 3 - 4 5 - 6 6 NPV 35. 36. Cash flows $(52,000) 14,000 11,000 9,000 7,500 PV Factor 1.0000 1.7356 1.4343 1.1854 0.5645 Present Value $(52,000) 24,298 15,777 10,669 4,234 $ 2,978

(9) Chapter 14 Capital Budgeting c. PI = ($52,000 + $2,978) $52,000 = 1.06 377

(10) Chapter 14 Capital Budgeting 378 37. 38. a. Investment ÷ Annual Savings = $2,300,000 ÷ $300,000 = 7.67 years. b. Point in Time Cash Flows 0 $(2,300,000) 1 - 11 300,000 NPV c. PI = $1,948,530 ÷ $2,300,000 = 0.85 d. PV = discount factor annual cash inflow $2,300,000 = discount factor $300,000 discount factor = $2,300,000 ÷ $300,000 = 7.6667 discount factor of 7.6667 corresponds to an IRR ≈ 7% a. Straight-line method Annual depreciation = $1,000,000 ÷ 5 years = $200,000 per year Tax benefit = $200,000 0.35 = $70,000 PV = $70,000 3.7908 = $265,356 PV Factor 1.0000 6.4951 Present Value $(2,300,000) 1,948,530 $ (351,470) b. Accelerated method $1,000,000 0.40 0.35 .9091 = $127,274.00 $ 600,000 0.40 0.35 .8265 = 69,426.00 $ 360,000 0.40 0.35 .7513 = 37,865.52 $ 216,000 0.40 0.35 .6830 = 20,653.92 * $ 129,600 0.35 .6209 = 28,164.02 Total $283,383.46 *In the final year, the remaining undepreciated cost is expensed. c. The depreciation benefit computed in part (b). exceeds that computed in part (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.

(11) Chapter 14 Capital Budgeting 39. a. 379 SLD = $40,000,000 ÷ 8 years = $5,000,000 per year Before-tax CF Less depreciation Before-tax NI Less tax (30%) NI Add depreciation After-tax CF $8,400,000 5,000,000 $3,400,000 1,020,000 $2,380,000 5,000,000 $7,380,000 Point in Time Cash Flows 0 $(40,000,000) 1 - 8 7,380,000 NPV The project is acceptable. b. Before-tax CF Less Depreciation Before-tax NI Tax (tax benefit) After-tax NI Add Depreciation After-tax CF PV Factor 1.0000 5.7466 Years 1 and 2 $ 8,400,000 9,200,000 $ (800,000) (240,000) $ (560,000) 9,200,000 $ 8,640,000 Point in time Cash flows 0 $(40,000,000) 1 - 2 8,640,000 3 - 8 6,960,000 NPV The project is acceptable. PV factor 1.0000 1.7833 3.9633 Present Value $(40,000,000) 42,409,908 $ 2,409,908 Years 3-8 $8,400,000 3,600,000 $4,800,000 1,440,000 $3,360,000 3,600,000 $6,960,000 Present Value $(40,000,000) 15,407,712 27,584,568 $ 2,992,280

(12) Chapter 14 Capital Budgeting 380 c. Recomputation of part (a): Before-tax CF $8,400,000 Less depreciation 5,000,000 NIBT $3,400,000 Less tax (50%) 1,700,000 NI $1,700,000 Add depreciation 5,000,000 After-tax CF $6,700,000 Point in Time Cash Flows PV Factor 0 $(40,000,000) 1.0000 1 - 8 6,700,000 5.7466 NPV The project is not acceptable. Recomputation of part (b): Years 1 and 2 Before-tax CF $ 8,400,000 Less Depreciation 9,200,000 NIBT $ (800,000) Less Tax(tax benefit) (400,000) After-tax NI $ (400,000) Add Depreciation 9,200,000 After-tax CF $ 8,800,000 Present Value $(40,000,000) 38,502,220 $ (1,497,780) Years 3-8 $8,400,000 3,600,000 $4,800,000 2,400,000 $2,400,000 3,600,000 $6,000,000 Point in Time Cash Flows PV Factor 0 $(40,000,000) 1.0000 1 - 2 8,800,000 1.7833 3 - 8 6,000,000 3.9633 NPV The project is not acceptable. 40. Present Value $(40,000,000) 15,693,040 23,779,800 $ (527,160) a. Tax: $25,000 - $8,000 = $17,000 Financial accounting: $25,000 - $15,000 = $10,000 b. CFAT = Market value now minus taxes = $17,000 - (($17,000 - $8,000) .40) = $13,400 c. CFAT = $4,000 - (($4,000 - $8,000) .40) = $5,600

(13) Chapter 14 Capital Budgeting 41. a. 381 Find the rate that will cause the NPVs of the two projects to be equal. By trial and error, the indifference rate is just above 4%. At a 4% rate the NPV of each project is computed as follows: Project 1: NPV = (8.1109 $85,000) - $400,000 NPV = $289,427 Project 2: NPV = (8.1109 $110,000) - $600,000 NPV = $292,199 b. This rate is known as the Fisher rate. c. Project 1: NPV = (5.6502 $85,000) - $400,000 NPV = $80,267 Project 2: NPV = (5.6502 $110,000) - $600,000 NPV = $21,522 Project 1 would be preferred due to its higher NPV, 42. 43. a. cash flow annuity factor = $30,000 cash flow 3.6048 = $30,000 cash flow = $8,322 b. $30,000 ÷ $8,322 = 3.6 years PV factor $180,000 = $400,000 PV factor = $400,000 ÷ $180,000 = 2.2222 This factor falls between 1.7591 (at 2 years) and 2.5313 (at 3 years) in the table using the 9% column. Thus, the cash flow would have to persist for over 2 years but under 3 years. 44. a. cash flow discount factor = investment cash flow 7.1607 = $1,200,000 cash flow = $167,581 b. cash flow discount factor = investment $193,723 discount factor = $1,200,000 discount factor = 6.1944 This PV factor for 12 periods corresponds to 12%.

(14) Chapter 14 Capital Budgeting 382 45. future value × discount factor = present value future value × .5674 = $14,000 future value = $24,674 46. Cost = $9,000 + PV($1,200 annuity) = $9,000 + ($1,200 × 30.1075) = $45,129 47. a. PV = future value × discount factor = $50,000 .6302 = $31,510 should be invested to achieve the goal b. PV = future value discount factor = $200,000 .3083 = $61,660 would be equivalent today c. PV = future value discount factor = $60,000 .3522 = $21,132 d. timeline time t0 amount t1 $210 t2 $210 t3 $210 t4 $210 t5 $210 Year 1 receipt: Year 2 receipt: Year 3 receipt: Year 4 receipt: Year 5 receipt: Present value Discount factors $210,000 $210,000 $210,000 $210,000 $210,000 × × × × × .9246 .8548 .7903 .7307 .6756 = $194,166 = 179,508 = 165,963 = 153,447 = 141,876 $834,960 based on semi-annual rate of 4 percent. e. Year 1 receipt: Year 2 receipt: Year 3 receipt: Year 4 receipt: Year 5 receipt: Year 6 receipt: Year 7 receipt: Year 8 receipt: Year 9 receipt: Year 10 receipt: Present value $ 30,000 $ 50,000 $ 60,000 $100,000 $100,000 $100,000 $100,000 $100,000 $ 70,000 $ 45,000 .9259 .8573 .7938 .7350 .6806 .6302 .5835 .5403 .5003 .4632 f. No. Using any discount rate above 0, the present value of the future annual cash flows is well below $1,000,000. = $ 27,777 = 42,865 = 47,628 = 73,500 = 68,060 = 63,020 = 58,350 = 54,030 = 35,021 = 20,844 $491,095

(15) Chapter 14 Capital Budgeting 383 Only if the friend has substantial other assets would she be a millionaire.

(16) Chapter 14 Capital Budgeting 384 48. a. Change in net income = $250,000 - ($500,000 ÷ 5) = $150,000 ARR = $150,000 ÷ ($500,000 ÷ 2) = 60% Payback = $500,000 ÷ $250,000 per year = 2 years 49. 50. b. Yes. The equipment investment meets all investment criteria. The payback is less than 5 years and the accounting rate of return exceeds 18%. a. Annual cash receipts Cash expenses Net cash flow before taxes Depreciation Income before tax Taxes Net income Depreciation Annual after-tax cash flow b. Payback = $50,000 $12,017 per year = 4.16 years c. ARR = $3,684 ($50,000 2) = 14.74% a. Before-tax cash flow Depreciation ($60,000 ÷ 5) Income before tax Tax (28%) Net income Depreciation Annual after-tax cash flow b. c. Point in time Cash flows PV factor 0 $(60,000) 1.0000 1-5 $ 21,360 3.7908 NPV From part a. accounting income = $9,360 d. ARR = $9,360 ÷ (($60,000 + $0) ÷ 2) $16,000 (2,000) $14,000 8,333 $ 5,667 (1,983) $ 3,684 8,333 $12,017 $ 25,000 (12,000) $ 13,000 (3,640) $ 9,360 12,000 $ 21,360 Present Value $(60,000) 80,971 $ 20,971 = 31.2% Payback = $60,000 $21,360 = 2.81 years

(17) Chapter 14 Capital Budgeting 51. 52. 385 a. Payback = $750,000 $250,000 annually b. One of the other cost savings may come in the form of improved quality. By adopting the higher technology, fewer defects should occur. Additionally, the company may be able to lower its costs because of its enhanced flexibility to switch production from one job to another. Additional costs may come in the form of maintenance and repairs as well as training costs to upgrade skills of workers to operate the new equipment. = 3 years Some of the factors that would weigh in favor of proceeding with the investment as planned include these: • The cost savings will be received now instead of later. • Any learning curve effects will be enjoyed earlier. • Any quality effects on operations will be recognized sooner. • The reduced maintenance cost benefit will occur now rather than later. • Demand for services may accelerate unexpectedly. • Delays in installing the equipment may result in price hikes that could be avoided if the equipment is installed on schedule. The factors that might weigh in favor of delaying investment include these: • Risk associated with the new investment may increase because of the likelihood that demand will not pick up in the near future. • Possible price reductions might be realized by delaying acquisition of the equipment. Price reductions are more likely on computerized equipment. • Possible layoffs of employees can be deferred. • More time is now available to evaluate alternative technologies that may have emerged or will emerge soon. • The company should protect its cash flow in light of a local, stagnating economy.

(18) 386 Chapter 14 Capital Budgeting 53. A company’s R&D program is the major source of distant, future cash flows. It is from the R&D effort that new products are identified and developed. Without a successful R&D program, the stream of future cash flows will dry up. Similarly, the present products and services offered by a firm are attributable to past R&D programs. Hence, the linkage is established between R&D activity, and present and future cash flows. It is not surprising that much long-term planning should be concentrated on the R&D activity. Managing the investment in R&D activities is the main method available to managers to balance current and present cash flows, as well as present and future growth. R&D is expensed when incurred and this reduces current earnings. This often tends to depress stock prices. 54. The capital budget interacts with the cash budget in that acquisition of capital items represents a use of cash. The capital budget also interacts with the statement of cash flows investing activities section. Further, the capital budget impacts depreciation expense on the budgeted income statement, and assets on the budgeted balance sheet. Indirectly, the capital budget interacts with other lines on the income statement because the various projects included in the capital budget will influence a variety of expenses including labor, overhead, administration and marketing. 55. No response provided. 56. The market must be expecting an enormous increase in future cash flows relative to current cash flows. If the total value of the shares is viewed as the present value of the future cash flows accruing to the equity holders, the only possible explanation for the incredibly high value of the stock is that investors expect future cash flows to be many times the level of current cash flows. 57. If the value of a share of stock is viewed as the present value of the future cash flows that will accrue to that share of stock, then any change in the discount rate applied by investors would affect the share price. If interest rates move up and down, it is reasonable to expect stock prices to move inversely to the change in interest rates because the change in the prevailing interest rates represents a change in the discount rate applied by investors.

(19) Chapter 14 Capital Budgeting 58. 387 The capital budget is a key control tool for a .com firm. Few .com firms have turned a profit yet. They are very early in the process of developing products and services to deliver over the Internet and this process requires substantial capital investment. Consequently, their investing activities, managed by the capital budgeting process, are the focus of much managerial time and talent. Only if these firms invest in the right projects will the eventual success of the firm be realized. Problems 59. a. ($000s omitted) t0 t1 t2 t3 t4 t5 t6 t7 t8 Investment -90.0 New CM 24.00 24.0 24.0 24.0 24.00 24.00 24.00 24.00 Oper. costs 0.0 -6.50 -7.2 -7.2 -7.2 -7.95 -9.45 -10.00 -11.25 Ann. savings -90.0 17.50 16.8 16.8 16.8 16.05 14.55 14.00 12.75 Year Cash Savings Cumulative Savings 1 $17,500 $17,500 2 16,800 34,300 3 16,800 51,100 4 16,800 67,900 5 16,050 83,950 Payback = 5 + (($90,000 - $83,950) $14,550) = 5.42 years b. 60. c. Time 0 1 2 3 4 5 6 7 8 NPV Cash Flow $(90,000) 17,500 16,800 16,800 16,800 16,050 14,550 14,000 12,750 a. Time: t0 t1 t2 t3 t4 t5 t6 t7 Amount: ($31,000) $6,800 $7,100 $7,300 $7,000 $7,000 $7,100 $7,200 b. Year Year Year Year Year 1 2 3 4 PV Factor for 10% 1.0000 .9091 .8265 .7513 .6830 .6209 .5645 .5132 .4665 Cash Flow $6,800 7,100 7,300 7,000 Present Value $(90,000) 15,909 13,885 12,622 11,474 9,965 8,213 7,185 5,948 $(4,799) Cumulative $ 6,800 13,900 21,200 28,200 Payback = 4 years + (($31,000-$28,200)$7,000) = 4.40 years

(20) Chapter 14 Capital Budgeting 388 c. Cash flow Description Purchase the car Cost savings Cost savings Cost savings Cost savings Cost savings Cost savings Cost savings NPV 61. 62. Time t0 t1 t2 t3 t4 t5 t6 t7 Amount ($31,000) 6,800 7,100 7,300 7,000 7,000 7,100 7,200 Discount Present Factor Value 1.0000 ($31,000) .8929 6,072 .7972 5,660 .7118 5,196 .6355 4,448 .5674 3,972 .5066 3,597 .4524 3,257 $ 1,202 a. Payback period = $64,000 ÷ ($25,000 - $4,500) = 3.12 years; the project does meet the payback criterion. b. Discount factor = Investment ÷ annual cash flow = $64,000 ÷ $20,500 = 3.1220 Discount factor of 3.1220 indicates IRR > 10.5% which is an unacceptable IRR. The actual IRR is 10.71%. a. Year 0 1-7 7 NPV b. No, the NPV is negative; therefore this is an unacceptable project. c. PI = ($2,111,344 + $109,400) ÷ $2,500,000 = 0.89 d. 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. Cash flow $(2,500,000) 419,500 200,000 PV factor 1.0000 5.0330 .5470 PV $(2,500,000) 2,111,344 109,400 $ (279,256)

(21) Chapter 14 Capital Budgeting 63. a. 389 The incremental cost of the new machine: $290,000 - $6,000 = $284,000 Cash flow Discount Description Time Amount Factor Incremental cost t0 $(284,000) 1.0000 Cost savings t1-t7 60,000 4.9676 NPV PI = $298,056 ÷ $284,000 = 1.05 Present Value $(284,000) 298,056 $ 14,056 Yes, the machine should be purchased because the NPV > 0 and the PI > 1. b. Payback = $284,000 ÷ 60,000 per year = 4.73 years c. Net investment ÷ annual annuity = discount factor of IRR $284,000 ÷ 60,000 = 4.7333 Discount factor of 4.7333 is between 13.0 and 13.5% Using interpolation, the actual rate is 13.40% 64. a. Computation of net annual cash flow: Increase in revenues $172,000 Increase in cash expenses (75,000) Increase in pretax cash flow $ 97,000 Less Depreciation (39,000) Income before tax $ 58,000 Income taxes (30 percent) (17,400) Net income $ 40,600 Add Depreciation 39,000 After-tax cash flow $ 79,600 Cash Flow Discount Description Time Amount Factor Initial cost t0 $(780,000) 1.0000 Annual cash flow t1-t20 79,600 7.9633 NPV b. Present Value $(780,000) 633,879 $(146,121) No, this is not an acceptable investment. The net present value is not close to the cutoff value of $0.

(22) Chapter 14 Capital Budgeting 390 c. Minimum annual cash flow discount factor = $780,000 Minimum annual cash flow 7.9633 = $780,000 Minimum annual cash flow = $97,949 After-tax cash flow increase = Minimum cash flow - Actual cash flow After-tax cash flow increase = $97,949 - $79,600 After-tax cash flow increase = $18,349 Increase in revenues = After-tax cash flow increase ÷ (1tax rate) Increase in revenues = $18,349 ÷ 0.70 Increase in revenues = $26,213 65. a. Cash flow after tax (CFAT): Year Pretax CF Depreciation 1 $52,000 $32,000 2 59,000 51,200 3 59,000 30,400 4 51,000 24,000 5 43,000 22,400 Timeline: t0 t1 $(160,000) $46,000 b. t2 $56,660 Tax $6,000 2,340 8,580 8,100 6,180 t3 $50,420 CFAT $46,000 56,660 50,420 42,900 36,820 t4 $42,900 t5 $36,820 Year Net Cash Flow Cumulative Cash Flow 1 $46,000 $ 46,000 2 56,660 102,660 3 50,420 153,080 Payback = 3 years + (($160,000-153,080) $42,900) = 3.16 years. Net present value: Time Amount Year 0 $(160,000) Year 1 $46,000 Year 2 56,660 Year 3 50,420 Year 4 42,900 Year 5 36,820 NPV Discount Factor 1.0000 .9259 .8573 .7938 .7350 .6806 Present Value $(160,000) 42,591 48,575 40,023 31,532 25,060 $ 27,781 Profitability index = ($160,000 + $27,781) ÷ $160,000 = 1.17 IRR, is between 14.5% and 15%. is found to be 14.68%. Using a computer, the IRR

(23) Chapter 14 Capital Budgeting 391

(24) Chapter 14 Capital Budgeting 392 66. a. b. Maple Commercial Plaza: t0 t1-t10 $(800,000) $210,000 t10 $400,000 High Tower: t0 $(3,400,000) t10 $1,500,000 t1-t10 $830,000 Maple Commercial Plaza: Calculation of annual cash flow: Pretax cost savings Depreciation ($800,000 25) Pretax income Taxes (40 percent) Aftertax income Depreciation Aftertax cash flow $210,000 (32,000) $178,000 (71,200) $106,800 32,000 $138,800 t0 t1-t10 t10 $(800,000) $138,800 $432,000* *Includes $32,000 from tax loss on sale (0.40 ($400,000 - $480,000)) High Tower: Calculation of annual cash flow: Pretax cost savings Depreciation ($3,400,000 25) Pretax income Taxes Aftertax income Depreciation Aftertax cash flow $ 830,000 (136,000) $ 694,000 (277,600) $ 416,400 136,000 $ 552,400 t0 t1-t10 t10 $(3,400,000) $552,400 $1,716,000* *Includes $216,000 from tax loss on sale (0.40 ($1,500,000 - $2,040,000))

(25) Chapter 14 Capital Budgeting c. After-tax NPV, Maple Commercial Plaza: Amount Discount Factor Year 0 $(800,000) 1.0000 Year 1-10 138,800 5.8892 Year 10 432,000 .3522 NPV 393 Present Value $(800,000) 817,421 152,150 $ 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 d. After-tax NPV, Hightower: Amount Discount factor Year 0 $(3,400,000) 1.0000 Year 1-10 180,400 5.8892 * Year 1-10 372,000 4.1925 Year 10 1,716,000 .3522 NPV *Rental Present Value $(3,400,000) 1,062,412 1,559,610 604,375 $ (173,603) portion of cash flow = $620,000 (1 - tax rate) = $620,000 0.60 = $372,000 Under this circumstance, Maple Commercial Plaza is the preferred investment.

(26) Chapter 14 Capital Budgeting 394 67. a. Year 0 1-6 NPV Cash Flow $(96,000) 25,600 Project A PV Factor 1.0000 4.1114 PV $(96,000) 105,252 $ 9,252 PI = $105,252 ÷ $96,000 = 1.10 IRR: Discount factor for 6 periods is $96,000 ÷ $25,600 = 3.7500, which yields a rate of just under 15.5%. Year 0 1-10 NPV Project B Cash Flow PV Factor $(160,000) 1.0000 30,400 5.6502 PV $(160,000) 171,766 $ 11,766 PI = $171,766 ÷ $160,000 = 1.07 IRR: Discount factor for 6 periods is $160,000 ÷ $30,400 = 5.2631, which yields a rate of about 13.75%. b. Although the methods give conflicting results, the NPV of B is greater than that of A and this is probably the best indication for choice. Although the IRR for Project A is higher, the reinvestment assumption of that method is less attainable. Even though the PI of Project A is slightly higher, its NPV is less and usually dollars are the deciding criterion when rates are close. c. Project A's IRR is 15.5% and Project B's is 13.75%. Above 13.75%, Project B will have a negative NPV. At 12%, Project A's NPV is $9,252 and Project B's is $11,766. By repeated trials, the Fisher rate (the rate at which the NPVs are equal) is estimated to be between 12.50% and 13.0%. By programmable calculator, the rate is found to be 12.64%.

(27) Chapter 14 Capital Budgeting 68. 69. 395 a. Project name NPV Film studios $3,578,846 Cameras & equipment 1,067,920 Land investment 2,250,628 Motion picture #1 1,040,276 Motion picture #2 1,026,008 Motion picture #3 3,197,363 Corporate aircraft 518,916 PVI 1.18 1.33 1.45 1.06 1.09 1.40 1.22 b. Ranking according to: NPV PVI 1. Film Studios Land investment 2. MP #3 MP#3 3. Land Invest. Camera & Equip. 4. Cam. & Equip. Corp. Aircraft 5. MP #1 Film Studio 6. MP #2 MP #2 7. Corp. aircraft MP #1 IRR 13.03% 18.62 19.69 12.26 14.22 21.34 18.15 IRR MP #3 Land Investment Camera & Equip. Corp. Aircraft MP #2 Film Studios MP #1 c. Suggested purchases 1. MP #3 @ $8,000,000 2. Land invest. @ $5,000,000 3. Cam. & Equip. @ $3,200,000 4. Corp. Aircraft @ $2,400,000 Total NPV NPV $3,197,363 2,250,628 1,067,920 518,916 $7,034,827 a. Depreciation per year = $2,000,000 ÷ 14 = $142,857 Before tax cash flows = [300 0.80 ($75 - $10) 50] $100,000 = $680,000 per year Before-tax CF $680,000 Less Depreciation (142,857) Income before tax $537,143 Less tax (35%) (188,000) Net income $349,143 Add Depreciation 142,857 After-tax cash flow $492,000 PV of 14 yr. annuity of $492,000 @ 13% Less cost NPV $3,100,830 (2,000,000) $1,100,830 b. It exceeds the highest rate provided in the table. By computer it is 23.29%. c. Cash flow discount factor = $2,000,000 Cash flow (6.3025) = $2,000,000

(28) Chapter 14 Capital Budgeting 396 Cash flow = $317,334

(29) Chapter 14 Capital Budgeting 70. 397 d. 6 years e. $217,425 after tax CF [($217,425 - $142,857) ÷ 0.65] + $142,857 + $100,000 = $357,577 before tax CF ($357,577 ÷ 300) ÷ $65 = 19 rooms (rounded up) a. Year 1 - 4 5 - 8 9 - 10 Revenue $125,000 175,000 100,000 Year 0 1 - 4 5 - 8 9 - 10 10 NPV Cash Flow $(145,000) 30,000 50,000 20,000 10,000 Year 1 - 4 5 - 8 9 - 10 Revenue $120,000 200,000 103,000 Year 0 1 - 4 5 - 8 9 - 10 10 Cash flow $(137,500) 27,000 52,500 11,050 23,500 b. c. VC $ 75,000 105,000 60,000 FC $20,000 20,000 20,000 PV Factor 1.0000 3.1699 2.1651 .8096 .3855 VC $ 78,000 130,000 66,950 FC $15,000 17,500 25,000 PV Factor 1.0000 3.1699 2.1651 .8096 .3855 NPV Net Cash Flow $ 30,000 50,000 20,000 PV $(145,000) 95,097 108,255 16,192 3,855 $ 78,399 Net Cash Flow $27,000 52,500 11,050 PV $(137,500) 85,587 113,668 8,946 9,059 $ 79,760 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.

(30) Chapter 14 Capital Budgeting 398 71. a. Year 1 2 3 4 5 6 7 8 Net Income $(107,500) (40,000) 5,500 88,000 240,000 240,000 72,000 (42,000) $456,000 Average annual income = $456,000 ÷ 8 = $57,000 Average Investment = (Cost + Salvage) ÷ 2 = ($1,600,000 + $0) ÷ 2 = $800,000 ARR = $57,000 ÷ $800,000 = 7.125% b. Year 1 2 3 4 5 6 Cash Receipts $750,000 800,000 930,000 1,280,000 1,600,000 1,600,000 Cash Expenses $ 657,500 640,000 724,500 992,000 1,160,000 1,160,000 Net Inflows $ 92,500 160,000 205,500 288,000 440,000 440,000 Cumulative Cash Flows $ 92,500 252,500 458,000 746,000 1,186,000 1,626,000 Payback = 5 + (($1,600,000-$1,186,000)÷ $440,000) years = 5.94 years c. Year 0 1 2 3 4 5 6 7 8 NPV Cash flow $(1,600,000) 92,500 160,000 205,500 288,000 440,000 440,000 272,000 158,000 PV factor 1.0000 .8929 .7972 .7118 .6355 .5674 .5066 .4524 .4039 PV $(1,600,000) 82,593 127,552 146,275 183,024 249,656 222,904 123,053 63,816 $ (401,127)

(31) Chapter 14 Capital Budgeting 72. a. 399 Initial cost: t0 = $(730,000) + $170,000 = $(560,000) Annual cash flow: Additional revenue ($1.20 110,000) $132,000 Labor savings 30,000 Other operating savings ($192,000 - $80,000) 112,000 Total $274,000 NPV = $(560,000) + ($274,000 6.1446) = $1,123,620 b. Discount factor = $560,000 $274,000 = 2.0438 The IRR exceeds numbers reported in the present value appendix. By computer, the IRR is found to be 47.96%. c. $560,000 $274,000 = 2.04 years d. ARR = ($274,000 - $31,000) (($560,000 + $0) 2) = 86.79% e. Incremental revenue ($132,000 10 years) Labor cost savings ($30,000 10 years) Savings in other costs ($112,000 10 years) Less incremental cost Incremental profit $1,320,000 300,000 1,120,000 (560,000) $2,180,000 Because the incremental profit is greater than $0, the firm should buy the new equipment.

(32) Chapter 14 Capital Budgeting 400 Cases 73. Note: Students may have slightly different answers. The CMA solution uses only two-digit present value factors. a. Present Value Analysis (using 6%) Initial Outlay 2003 2004 Internal Financing Outlay ($1,000,000) Depr. tax shield Net CF ($1,000,000) PV factors 1.00 NPV ($1,000,000) Bank Loan Outlay Loan payment Interest tax shield Depr. tax shield Net CF PV factors NPV Lease Outlay Tax shield on outlay Payments net of tax ($220,000 60%) NCF PV factors NPV $160,000 $160,000 0.94 $150,400 $ 96,000 $ 96,000 0.89 $ 85,440 2005 $ 57,600 $ 57,600 0.84 $ 48,384 2006 $ 43,200 $ 43,200 0.79 $ 34,128 2007 NPV $ 43,200 $ 43,200 0.75 $ 32,400 $(649,248) ($100,000) ($237,420)($237,420)($237,420)($237,420)($237,420) 36,000 30,103 23,617 16,482 8,638 $160,000 $ 96,000 $ 57,600 $ 43,200 $ 43,200 ($100,000) ($ 41,420)($111,317)($156,203)($177,738)($185,582) 1.00 0.94 0.89 0.84 0.79 0.75 ($100,000) ($ 38,935)($ 99,072)($131,211)($140,413)($139,187)$(648,818) ($ 50,000) $ 20,000 ($132,000)($132,000)($132,000)($132,000)($132,000) ($ 50,000) ($112,000)($132,000)($132,000)($132,000)($132,000) 1.00 0.94 0.89 0.84 0.79 0.75 ($ 50,000) ($105,280)($117,480)($110,880)($104,280)($ 99,000)$(586,920) NPV for internal financing = $(649,248) NPV for bank loan = $(648,818) NPV for lease = $(586,920)

(33) Chapter 14 Capital Budgeting 401 Supporting calculations Depreciation tax shield Year Depreciation Rate Tax shield 1 $1,000,000 0.40 = $400,000 0.40 = $160,000 2 ($1,000,000-$400,000) 0.40 = 240,000 0.40 = 96,000 3 ($1,000,000-$640,000) 0.40 = 144,000 0.40 = 57,600 4 ($1,000,000-$784,000) 0.50 = 108,000 0.40 = 43,200 5 ($1,000,000-$784,000) 0.50 = 108,000 0.40 = 43,200 Interest tax shield Year Interest Rate Tax shield 1 $90,000 0.40 $36,000 2 75,258 0.40 30,103 3 59,042 0.40 23,617 4 41,204 0.40 16,482 5 21,596 0.40 8,638 1. Metrohealth should employ the cost of debt of six percent (which represents the after-tax effect of the ten percent incremental borrowing rate) as a discount rate in calculating the net present value for all three financing alternatives. Investment decisions (accept versus reject) and financing decisions should be separated. Cost of capital or hurdle rates apply to investment decisions but not to financing decisions. This application is a financing decision. Incremental cost of debt is the basic rate used for discounting in financing decisions because the assumption made is that the firm would have no idle cash available for funding and would have to borrow from an outside lending institution at the incremental borrowing rate (10 percent in this case). 2. The financing alternative most advantageous to Metrohealth is leasing. This alternative has the lowest net present value ($586,920) when compared to the other two alternatives.

(34) Chapter 14 Capital Budgeting 402 74. b. Some qualitative factors Paul Monden should include for management consideration before deciding on the financing alternatives are: ◼ The differential impact from one financing method versus another for equipment acquisitions due to various health care, third-party payor, reimbursement scenarios (the federal government with DRG reimbursement or insurance company reimbursement). ◼ The technology of the equipment along with the risk of technological obsolescence. If major technological advances are expected, the preferred qualitative choice would be leasing from a lessor who would absorb any loss due to equipment obsolescence. ◼ The maintenance agreement included in the operating lease. (CMA adapted) a. Incremental annual after-tax cash flows: Purchase Purchase of new equipment One time production expense net of tax ($30,000 .6) Sale of old equipment net of tax ($5,000 .6) Total initial cash outflow Year 1 Cash operating savings $ 90,000 Less tax effect(40%) (36,000) Cash savings after-tax $ 54,000 Depr. tax shield (see sched. below) 48,000 After-tax operating cash flows $102,000 Year 1 2 3 4 Annual Operations Year 2 Year 3 Year 0 $(300,000) (18,000) 3,000 $(315,000) Year 4 $150,000 (60,000) $150,000 $150,000 (60,000) (60,000) $ 90,000 $ 90,000 $ 90,000 36,000 24,000 12,000 $126,000 $114,000 $102,000 Depreciation Schedule Depreciable base: $300,000 Life: four-year limit Method: Sum-of-the-years'-digits Rate Depreciation Depr. Shield 4/10 $120,000 $48,000 3/10 90,000 36,000 2/10 60,000 24,000 1/10 30,000 12,000

(35) Chapter 14 Capital Budgeting b. 403 The company should accept the proposal since the NPV is positive. Year 0 1 2 3 4 NPV Cash Flow $(315,000) 102,000 126,000 114,000 102,000 12% PV Factor 1.0000 .8929 .7972 .7118 .6355 PV $(315,000) 91,076 100,447 81,145 64,821 $ 22,489 (CMA) 75. 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. 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 may 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)

(36) Chapter 14 Capital Budgeting 404 Reality Check 76. 77. 78. a. It is no easier for a healthcare concern than any other business to invest in capital assets when doing so is not justified on financial grounds. The problem described in the article would seem to describe a failure of the information systems of healthcare providers to fairly capture all relevant financial dimensions of long-term strategic investments. It is unreasonable to think that benefits such as “improving quality of care or patient satisfaction” have no financial return. b. As an accountant with a healthcare provider, you could identify “nonfinancial” benefits such as those described in part a. and, if appropriate, assign values to them. The key contribution you would make is to provide a rigorous investment analysis that includes not only those costs and benefits usually captured by accounting systems, but to add other benefits that may be missed because the financial impact is indirect (e.g., increased consumer satisfaction) rather than direct. a. For labor-intensive operations, labor cost and quality would be substantial considerations in locating new investments. Having skilled labor available at a competitive cost would determine the likelihood that the new investment would be profitable. b. In addition to labor cost and quality, firms would also consider these factors: • Political risks of the alternative investment locations • Nearness to suppliers and markets • Tax rates of the alternative locations • Incentives offered by local governments • Location of competitors a. When short-run economic conditions become difficult, companies must be very careful when cutting costs to protect profits. In particular, cutting spending on training, research and development, and customer service will surely have a deleterious effect on product and service quality. Alternatively, cutting advertising costs and other marketing costs may have much less effect on product quality.

(37) Chapter 14 Capital Budgeting 79. 80. 405 b. Any cost-cutting measures that affect employee and managerial training or research and development will have long-term implications. In cutting these activities, the firm is essentially mining future profitability to protect current profitability. The consequence will be lower future profits, fewer product innovations, and underdeveloped human resources. a. Managers bear the burden of maximizing the wealth of their investors. To the extent that holding assets (as opposed to selling them) results in diminished wealth, the managers are failing in their obligation to the shareholders. Managers may have incentives to hold nonperforming assets if their compensation and incentives are related to the size of the firm. Even so, managers have an ethical obligation to pursue the maximization of investor wealth subject to ethical treatment of other stakeholders. This obligation is no less binding merely because it conflicts with the managers’ personal incentives. b. Spin-offs may result in the firing of workers or the downgrading of their jobs. Managers have a responsibility to see that workers who are involved in spin-offs are treated ethically. Disaffected workers should be given all the support services necessary to find comparable alternative employment. If possible, workers should be given opportunities to transfer to other operations of the company. Otherwise, workers should be provided with employment counseling and training necessary to finding equivalent employment with another firm. 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. Yes. 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

(38) 406 Chapter 14 Capital Budgeting value of leasing the vehicle.

(39)