CHAPTER 15

CAPITAL BUDGETING

QUESTIONS

1. A capital asset is a long-lived asset acquired by a firm. Capital assets provide the
essential production and distributional capabilities required by all organizations.

2. Cash flows are the focus of capital budgeting investments just as cash flows are
the focus of any investment. Accounting income ultimately becomes cash flow but
is reported based on accruals, deferrals, and other accounting assumptions and
conventions. These accounting practices and assumptions detract from the purity
of cash flows and, therefore, are not used in capital budgeting.

3. Time lines provide clear visual models of a projects expected cash inflows and out-
flows for each point in time. These graphics provide an efficient and effective means
to help organize the information needed to perform capital budgeting analyses.

4. The payback method measures the time expected for a firm to recover its investment
in a project. The method ignores the receipts expected to occur after the investment is
recovered and ignores the time value of money.

5. Return of capital means the investor is receiving the principal that was originally
invested. Return on capital means the investor is receiving an amount earned on
the investment (i.e., an amount in excess of the original investment).

6. A projects NPV is the present value of all cash inflows less the present value of
all cash outflows associated with the project. If NPV is zero, the project is ac-
ceptable because, in that case, it will exactly earn the required rate of return. Also,
when NPV equals zero, the projects internal rate of return equals the cost of capi-
tal.

7. It is highly unlikely that the estimated NPV will exactly equal the actual NPV
achieved because of the number of estimates necessary in the original computa-
tion. These estimates include project life and timing and amounts of cash inflows
and outflows. The original investment may also include an estimate of the amount
of working capital needed at the beginning of the project life.

8. The profitability index (PI) is calculated by dividing the discounted cash inflows
by the initial investment. The NPV method subtracts the initial investment from
the discounted net cash inflows to arrive at the net present value. Thus, each com-
putation uses the same amounts in different ways. By measuring the expected dol-
lars of discounted cash inflows per dollar of project investment, PI attempts to
measure the planned efficiency of the use of the money (i.e., output to input). A PI
equal to or greater than 1 is equivalent to a NPV equal to or greater than zero and
indicates that the investment will provide an acceptable return on capital.

426
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Chapter 15 427

9. The IRR is the rate that would cause the NPV of a project to equal zero. A project
is considered potentially successful (all other factors being acceptable) if the cal-
culated IRR equals or exceeds the companys cost of capital.

10. The amount of depreciation for a year is one factor that helps determine the
amount of cash outflow for income taxes. Therefore, although depreciation is not
a cash flow item itself, it does affect the size of another item (income taxes) that is
a cash flow.

11. The four questions are:

1. Is the activity worthy of an investment?
2. Which assets can be used for the activity?
3. Of the assets available for each activity, which is the best investment?
4. Of the best investments for all worthwhile activities, in which ones should the
company invest?

12. Risk is defined as the likely variability of an assets future returns. 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 of the organization
As risk increases, it should be taken into consideration in capital budgeting analy-
sis through raising the discount rate (or some other acceptable method) which, in
turn, lowers the NPV of a project.

13. In capital budgeting, 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 projects outcome will be significantly affected. This process gives the deci-
sion maker an indication of how much room there is for error in estimates for in-
put variables and which input variables need special attention.

14. Postinvestment audits are performed to determine whether the realized return
matches the expected return on a project. Postinvestment audits are typically per-
formed at or near the end of a projects life.

15. The time value of money refers to the concept that money has time-based earnings
power. Money can be loaned or invested to earn a rate of return. Present value is
always less than future value because of the time value of money. A future value
must be discounted to determine its equivalent (but smaller) present value. The
discounting process strips away the imputed rate of return in future values, thus
present values are less than future values.

16. ARR = Average annual profits Average investment

Unlike the rate used to discount cash flows or to compare to the cost of capital rate,
the ARR is not a discount rate to apply to cash flows. It is measured from accrual-
based accounting information and is not intended to be associated with cash flows.

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428 Chapter 15

EXERCISES
17. Investors are ultimately most interested in cash flows. Investors cannot spend ac-
counting income; they can only spend the cash that is derived from their invest-
ment in the firm. Investors are interested in accounting earnings because they
reveal information about present and future cash flows that is not revealed in ex-
amining only cash flows. Hence, accounting earnings are only useful to investors
if those earnings help inform the investors about cash flows.

18. Cash flows

Period: 0 1 2 3 4 5
(Purchase) 3,000,000
Savings 900,000 900,000 900,000 900,000 900,000
Accounting earnings
Period: 0 1 2 3 4 5
Expense savings 900,000 900,000 900,000 900,000 900,000
Depreciation 600,000 600,000 600,000 600,000 600,000
Increase in
accounting earnings 300,000 300,000 300,000 300,000 300,000

19. No solution provided.

20. The main point made should be that stock prices reflect the firms expected future
cash flows discounted at an appropriate risk-adjusted discount rate. The risk-adjusted
discount rate is a function of both the specific securitys risk and the prevailing
market interest rates. As market interest rates change, the value of securities change
alsoespecially those that have distant future cash flows that comprise a significant
portion of the securitys value, e.g., growth stocks.

21. a. Payback = $3,000,000 $600,000 per year = 5 years

b. Year Amount Cumulative Amount
1 $300,000 $ 300,000
2 300,000 600,000
3 300,000 900,000
4 300,000 1,200,000
5 300,000 1,500,000
6 400,000 1,900,000
7 400,000 2,300,000
8 400,000 2,700,000
9 400,000 3,100,000
10 400,000 3,500,000
The payback is eight years plus [(3,000,000 2,700,000) 400,000] or 8.75
years.

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Chapter 15 429

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

Year Amount Cumulative Amount
1 $70,000 $ 70,000
2 78,000 148,000
3 72,000 220,000
4 56,000 276,000
5 50,000 326,000
6 48,000 374,000
7 44,000 418,000
Payback = 4 years + [($320,000 $276,000) $50,000] = 4.9 years
Based on the payback criterion, Houston Fashions should not invest in the pro-
posed product line.
b. Yes. Houston Fashions should also use a discounted cash flow technique so as
to consider both the time value of money and the cash flows that occur after the
payback period.

23. Point in Time Cash Flows PV Factor Present Value

0 $(1,800,000) 1.0000 $(1,800,000)
1 280,000 0.8929 250,012
2 280,000 0.7972 223,216
3 340,000 0.7118 242,012
4 340,000 0.6355 216,070
5 340,000 0.5674 192,916
6 288,800 0.5066 146,306
7 288,800 0.4524 130,653
8 288,800 0.4039 116,646
9 260,000 0.3606 93,756
10 260,000 0.3220 83,720
NPV $ (104,693)
Based on the NPV, this is an unacceptable investment.

24. a. The contribution margin of each part is $1 (or $7.50 $6.50)

Contribution margin per year = $1 100,000 = $100,000
Point in Time Cash Flows PV Factor Present Value
0 $(500,000) 1.0000 $(500,000)
18 (20,000) 5.5348 (110,696)
18 100,000 5.5348 553,480
NPV $ (57,216)
b. Based on the NPV, this is not an acceptable investment.
c. Other considerations would include whether refusing to produce this part for
the customer would cause a loss of other business from that customer. The
company should also consider going back to the customer and asking for a
higher price that would cause the project to have a positive NPV.

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430 Chapter 15

25. PI = PV of cash inflows PV of cash outflows

= ($18,000 + $240,000) $240,000 = 1.08

26. a. PV of inflows: $91,000 6.4177 = $584,011

PV of investment: $600,000
PI = $584,011 $600,000 = 0.97
b. Cedar City Public Transportation should not add the bus route because the PI is
less than 1.00.
c. To be acceptable, a project must generate a PI of at least 1; a PI greater than 1
equates to an NPV > 0.

27. a. PV = Discount factor Annual cash inflow

$700,000 = Discount factor $144,000
Discount factor = $700,000 $144,000 = 4.8611
The IRR is 13 percent (rounded to the nearest whole percent).
b. Yes. The IRR on this proposal is greater than the firms hurdle rate of 7 percent.

c. $700,000 = 5.9713 Annual cash flow

Annual cash flow = $700,000 5.9713
Annual cash flow = $117,227

28. a. PV = Discount factor Annual cash inflow

$1,800,000 = Discount factor $300,000
Discount factor = $1,800,000 $300,000 = 6.0000
The IRR is 10.5 percent (rounded to the nearest half percent).
The project is acceptable because the IRR exceeds the discount rate.
b. The main qualitative factors would be the effect of the technology on the per-
ceived quality of the food that is processed by the new machinery. An addition-
al consideration would be the effect of the technology on employees,
particularly if the investment would cause layoffs.

29. Investment cost = $375,000 Discount factor for 14%, 7 years

= $375,000 4.2883 = $1,608,113
NPV = $375,000 Discount factor (10%, 7 years) $1,608,113
= ($375,000 4.8684) $1,608,113 = $217,537

30. a. Annual depreciation = $1,000,000 8 years = $125,000 per year

Tax benefit = $125,000 0.30 = $37,500
PV = $37,500 5.7466 = $215,498

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Chapter 15 431

b. Accelerated method
$1,000,000 0.30 0.40 0.9259 = $111,108
$600,000 0.30 0.40 0.8573 = 61,726
$360,000 0.30 0.40 0.7938 = 34,292
$216,000 0.30 0.40 0.7350 = 19,051
$129,600* 0.30 0.6806 = 26,462
Total $252,639
*
In the final year, the remaining undepreciated cost is expensed.

c. The depreciation benefit computed in (b) exceeds that computed in (a) solely
because of the time value of money. The depreciation method in (b) allows for
faster recapture of the cost; therefore, there is less discounting of the future cash
flows.

31. a. SLD = $18,000,000 8 years = $2,250,000 per year

Before-tax CF $ 3,100,000
Less depreciation (2,250,000)
Before-tax NI $ 850,000
Less tax (30%) (255,000)
NI $ 595,000
Add depreciation 2,250,000
After-tax CF $ 2,845,000
Point in Time Cash Flows PV Factor Present Value
0 $(18,000,000) 1.0000 $(18,000,000)
18 2,845,000 6.4632 18,387,804
NPV $ 387,804
The project is acceptable because the NPV is positive.
b. Years 1 and 2 Years 38
Before-tax CF $ 3,100,000 $ 3,100,000
Less depreciation (4,140,000) (1,620,000)
Before-tax NI $(1,040,000) $ 1,480,000
Tax (tax benefit) (312,000) 444,000
After-tax NI $ (728,000) $ 1,036,000
Add depreciation 4,140,000 1,620,000
After-tax CF $ 3,412,000 $ 2,656,000
Point in Time Cash Flows PV Factor Present Value
0 $(18,000,000) 1.0000 $(18,000,000)
12 3,412,000 1.8594 6,344,273
38 2,656,000 4.6038 12,227,693
NPV $ 571,966
The equipment investment is acceptable. Note, because of the more rapid de-
preciation used in (b) relative to (a), the NPV is more positive in (b) than in (a).

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432 Chapter 15

c. Before-tax CF $ 3,100,000
Less depreciation (2,250,000)
Before-tax NI $ 850,000
Less tax (40%) (340,000)
NI $ 510,000
Add depreciation 2,250,000
After-tax CF $ 2,760,000
Point in Time Cash Flows PV Factor Present Value
0 $(18,000,000) 1.0000 $(18,000,000)
18 2,760,000 6.4632 17,838,432
NPV $ (161,568)
The equipment investment is unacceptable because the NPV is negative.
Years 1 and 2 Years 38
Before-tax CF $ 3,100,000 $3,100,000
Less depreciation 4,140,000 1,620,000
Before-tax NI $(1,040,000) $1,480,000
Tax (tax benefit) (416,000) 592,000
After-tax NI $ (624,000) $ 888,000
Add depreciation 4,140,000 1,620,000
After-tax CF $ 3,516,000 $2,508,000
Point in Time Cash Flows PV Factor Present Value
0 $(18,000,000) 1.0000 $(18,000,000)
12 3,516,000 1.8594 6,537,650
38 2,508,000 4.6038 11,546,330
NPV $ 83,980
The equipment investment is acceptable.

32. a. Tax: $99,000 $18,000 = $81,000

Financial accounting: $99,000 $35,000 = $64,000
b. CFAT = Current market value Taxes
= $37,000 [($37,000 $18,000) 0.30] = $31,300

c. CFAT = $9,000 [($9,000 $18,000) 0.30] = $11,700

33. a. payback
b. NPV, PI
c. IRR
d. payback, NPV, PI, IRR
e. all methods
f. payback
g. ARR

34. a. payback, NPV, PI, IRR

b. payback
c. ARR

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Chapter 15 433

d. payback, ARR
e. payback, NPV, PI, IRR
f. all methods
g. IRR
h. payback, IRR, ARR, PI

35. a. Project Name NPV PI IRR

Film studios $3,578,910 1.18 13.03%
Cameras & equipment 1,067,920 1.33 18.62
Land improvement 2,250,628 1.45 19.69
Motion picture #1 1,040,276 1.06 12.26
Motion picture #2 1,026,008 1.09 14.09
Motion picture #3 3,197,320 1.40 21.32
Corporate aircraft 518,916 1.22 18.15
b. Ranking according to:
NPV PI IRR
1. Film studios Land improvement MP #3
2. MP #3 MP #3 Land improvement
3. Land improvement Cameras & equip. Cameras & equip.
4. Cameras & equip. Corp. aircraft Corp. aircraft
5. MP #1 Film studios MP #2
6. MP #2 MP #2 Film studios
7. Corp. aircraft MP #1 MP #1
c. Suggested purchases: NPV
1. Motion picture #3 @ $8,000,000 $3,197,320
2. Land improvement @ $5,000,000 2,250,628
3. Cameras & equipment @ $3,200,000 1,067,920
4. Corporate aircraft @ $2,400,000 518,916
Total NPV $7,034,784

36. a. Cash flow Annuity factor = $160,000

Cash flow 3.7908 = $160,000
Cash flow = $42,207
b. $160,000 $42,207 = 3.79 years

37. a. NPV = ($28,000 4.8684) $100,000 = $36,315

b. Annuity factor $28,000 = $100,000

Annuity factor = $100,000 $28,000 = 3.5714
This factor corresponds most closely to 20%

38. PV = FV Discount factor

$80,000 = FV 0.7473
FV = $80,000 0.7473 = $107,052

39. Cost = $8,000 + PV($800 annuity) = $8,000 + ($800 37.9740*) = $38,379.20

*
Discount factor for 48 months, 1%

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 434 Chapter 15

40. a. PV = Future value Discount factor

= $50,000 0.6302
= $31,510 should be invested to achieve the goal

b. PV = Future value Discount factor

= $400,000 0.3769
= $150,760 would be equivalent today

c. PV = Future value Discount factor

= $60,000 0.2146
= $12,876
d. Present value = Annuity Annuity discount factor
= $200,000 3.9927
= $798,540

e. Year 1 receipt: $ 50,000 0.9346 = $ 46,730

Year 2 receipt: $ 55,000 0.8734 = 48,037
Year 3 receipt: $ 60,000 0.8163 = 48,978
Year 4 receipt: $100,000 0.7629 = 76,290
Year 5 receipt: $100,000 0.7130 = 71,300
Year 6 receipt: $100,000 0.6663 = 66,630
Year 7 receipt: $100,000 0.6228 = 62,280
Year 8 receipt: $100,000 0.5820 = 58,200
Year 9 receipt: $ 70,000 0.5439 = 38,073
Year 10 receipt: $ 45,000 0.5084 = 22,878
Present value $539,396
f. No. Using any discount rate above 0, the present value of the future annual cash
flows is well below $1,000,000.

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

ARR = $5,600,000 ($72,000,000 2) = 15.6%
Payback = $72,000,000 $20,000,000 per year = 3.6 years
b. No. Although the dredge meets the payback criterion, it fails to meet the ARR
criterion of 18 percent.

42. 42. a. Annual cash receipts $15,000

Cash expenses (3,000)
Net cash flow before taxes $12,000
Depreciation (6,667)
Income before tax $ 5,333
Taxes (1,600)
Net income $ 3,733
Depreciation 6,667
Annual after-tax cash flow $10,400
b. Payback = $40,000 $10,400 per year = 3.8 years

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Chapter 15 435

c. ARR = $3,733 ($40,000 2) = 18.7%

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436 Chapter 15

PROBLEMS
43. a. A lease is found appealing by consumers because it often results in a lower
monthly payment than that which would have been required to purchase a spe-
cific car. Alternatively, the consumer could opt to make the payment required to
purchase the specific car but obtain a more expensive car under lease financ-
ing.
b. No. A consumer should be provided with all necessary information to make a
fair comparison between the lease and purchase alternative.
c. As an accountant, you could provide a financial comparison of the lease and
purchase alternatives. Using a discounted cash flow approach, you could com-
pare the present value of purchasing the vehicle to the present value of leasing
the vehicle.

44. a. Although the 8 percent hurdle rate may be appropriate for most projects, it may
be inappropriate to insist that a project such as a pollution abatement project be
required to meet any financial hurdle rate.
b. In the future, the company could face not only significant fines from government
regulators, but also financial claims filed by persons harmed by the arsenic.
c. Hernandez should justify the investment based both on the potential future fi-
nancial claims and that it is the socially and ethically correct action for the
company to take.

45. a. ($000s omitted)

t0 t1 t2 t3 t4 t5 t6 t7 t8
Investment (190)
New CM 60 60 60 60 60 60 60 60
Oper. costs 0 20 27 27 27 30 30 30 33
Cash flow (190) 40 33 33 33 30 30 30 27
b. Year Cash Flow Cumulative Cash Flow
1 $40,000 $ 40,000
2 33,000 73,000
3 33,000 106,000
4 33,000 139,000
5 30,000 169,000
6 30,000 199,000
Payback = 5 + [($190,000 $169,000) $30,000] = 5.7 years

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 Chapter 15 437

c. Time Cash Flow PV Factor for 8% Present Value

0 $(190,000) 1.0000 $(190,000)
1 40,000 0.9259 37,036
2 33,000 0.8573 28,291
3 33,000 0.7938 26,195
4 33,000 0.7350 24,255
5 30,000 0.6806 20,418
6 30,000 0.6302 18,906
7 30,000 0.5835 17,505
8 27,000 0.5403 14,588
NPV $ (2,806)

46. a. Time: t0 t1 t2 t3 t4 t5 t6 t7
Amount: ($41,000) $5,900 $8,100 $8,300 $8,000 $8,000 $8,300 $9,200

b. Year Cash Flow Cumulative

1 $5,900 $ 5,900
2 8,100 14,000
3 8,300 22,300
4 8,000 30,300
5 8,000 38,300
6 8,300 46,600
Payback = 5 years + [($41,000 $38,300) $8,300] = 5.3 years
c. Cash Flow Discount Present
Description Time Amount Factor Value
Purchase the truck t0 $(41,000) 1.0000 $(41,000)
Cost savings t1 5,900 0.9259 5,463
Cost savings t2 8,100 0.8573 6,944
Cost savings t3 8,300 0.7938 6,589
Cost savings t4 8,000 0.7350 5,880
Cost savings t5 8,000 0.6806 5,445
Cost savings t6 8,300 0.6302 5,231
Cost savings t7 9,200 0.5835 5,368
NPV $ (80)

44. 47. a. Year Cash Flow PV Factor PV

0 $(5,000,000) 1.0000 $(5,000,000)
17 838,000 5.5824 4,678,051
7 400,000 0.6651 266,040
NPV $ (55,909)
b. No, the NPV is negative; therefore this is an unacceptable project.
c. PI = ($4,678,051 + $266,040) $5,000,000 = 0.99

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438 Chapter 15

d. PV of annual cash flows = $5,000,000 $266,040

PV of annual cash flows = $4,733,960

PV of annual cash flows = Annual cash flow 5.5824

$4,733,960 = Annual cash flow 5.5824
Annual cash flow = $4,733,960 5.5824 = $848,015
Minimum labor savings = $848,015 + Operating costs
= $848,015 + $112,000
= $960,015
e. The company should consider the quality of work performed by the machine
compared to the quality of work performed by the individuals; the reliability of
the mechanical process compared to the manual process; and perhaps most im-
portantly, the effect on worker morale and the ethical considerations in displac-
ing 14 workers.

48. a. Payback period = $140,000 ($47,500 $8,500) = 3.6 years

The project does not meet the payback criterion.
b. Discount factor = Investment Annual cash flow
= $140,000 $39,000 = 3.5897
Discount factor of 3.5897 indicates IRR 4 %
This is an unacceptable IRR.
c. Foster should consider two main factors: (1) the effect of the computer system
on tax return accuracy and quality of service delivered to clients and (2) the ef-
fect of firing one employee on both the dismissed employee and the remaining
employees.

49. a. The incremental cost of the replacement equipment: $580,000 $12,000 =

$568,000
Cash Flow Discount Present
Description Time Amount Factor Value
Incremental cost t0 $(568,000) 1.0000 $(568,000)
Cost savings t1 t8 120,000 5.3349 640,188
NPV $ 72,188
PI = $640,188 $568,000 = 1.1
Yes, the replacement equipment should be purchased because the NPV > 0 and
the PI > 1.
b. Payback = $568,000 120,000 per year = 4.7 years
c. Net investment Annual annuity = Discount factor of IRR
$568,000 120,000 = 4.7333
Discount factor of 4.7333 is between 13.0 and 13.5 percent; therefore, to the
nearest whole percent, the IRR is 13 percent.

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Chapter 15 439

50. a. Computation of net annual cash flow:

Increase in revenues $ 46,000
Increase in cash expenses (21,000)
Increase in pre-tax cash flow $ 25,000
Less depreciation (9,750)
Income before tax $ 15,250
Income taxes (30 percent) (4,575)
Net income $ 10,675
Add depreciation 9,750
After-tax cash flow $ 20,425
Cash Flow Discount Present
Description Time Amount Factor Value
Initial cost t0 $(195,000) 1.0000 $(195,000)
Annual cash flow t1 t20 20,425 9.1286 186,452
NPV $ (8,548)
b. This is not an acceptable investment because the NPV is less than $0.

c. Minimum annual after tax cash flow Discount factor = $195,000

Minimum annual after tax cash flow 9.1286 = $195,000
Minimum annual after tax cash flow = $21,361
$21,361 = (Minimum cash revenues $21,000 $9,750)(1 Tax rate) + $9,750
$11,611 = (Minimum cash revenues $21,000 $9,750)(1 0.30)
$16,587 = Minimum cash revenues $30,750
Minimum cash revenues = $47,337
Proof: Computation of net annual cash flow:
Increase in revenues $ 47,337
Increase in cash expenses (21,000)
Increase in pre-tax cash flow $ 26,337
Less depreciation (9,750)
Income before tax $ 16,587
Income taxes (30 percent) (4,976)
Net income $ 11,611
Add depreciation 9,750
After-tax cash flow $ 21,361

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

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

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440 Chapter 15

b. Year Net Cash Flow Cumulative Cash Flow

1 $ 90,000 $ 90,000
2 112,540 202,540
3 97,980 300,520
4 83,100 383,620
Payback = 3 years + [($320,000 $300,520) $83,100] = 3.2 years
Net present value:
Time Amount Discount Factor Present Value
0 $(320,000) 1.0000 $(320,000)
1 90,000 0.9259 83,331
2 112,540 0.8573 96,481
3 97,980 0.7938 77,777
4 83,100 0.7350 61,079
5 71,580 0.6806 48,717
NPV $ 47,385
Profitability index = ($320,000 + $47,385) $320,000 = 1.1
IRR is 14 percent.

52. a. Maple Commercial Plaza:

t0 t1 t10 t10
$(800,000) $210,000 $400,000
High Tower:
t0 t1 t10 t10
$(3,400,000) $830,000 $1,500,000
b. Maple Commercial Plaza:
Calculation of annual cash flow:
Pre-tax cost savings $210,000
Depreciation ($800,000 25) (32,000)
Pre-tax income $178,000
Taxes (40 percent) (71,200)
After-tax income $106,800
Depreciation 32,000
After-tax cash flow $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)]

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Chapter 15 441

High Tower:
Calculation of annual cash flow:
Pre-tax cost savings $ 830,000
Depreciation ($3,400,000 25) (136,000)
Pre-tax income $ 694,000
Taxes (277,600)
After-tax income $ 416,400
Depreciation 136,000
After-tax cash flow $ 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)]

c. After-tax NPV, Maple Commercial Plaza:

Year Amount Discount Factor Present Value
0 $(800,000) 1.0000 $(800,000)
110 138,800 5.8892 817,421
10 432,000 0.3522 152,150
NPV $ 169,571
After-tax NPV, Hightower:
Year Amount Discount Factor Present Value
0 $(3,400,000) 1.0000 $(3,400,000)
110 552,400 5.8892 3,253,194
10 1,716,000 0.3522 604,375
NPV $ 457,569
Based on the NPV criterion, Hightower is the preferred investment.
d. After-tax NPV, Hightower:
Year Amount Discount Factor Present Value
0 $(3,400,000) 1.0000 $(3,400,000)
110 180,400 5.8892 1,062,412
110 372,000* 4.1925 1,559,610
10 1,716,000 0.3522 604,375
NPV $ (173,603)
*
Rental portion of cash flow = $620,000 (1 Tax rate)
= $620,000 0.60
= $372,000
In this circumstance, Maple Commercial Plaza is the preferred investment.

53. a. Depreciation per year = $1,500,000 14 = $107,143

Before tax cash flows = [300 0.80 ($70 $20) 50] $250,000
= $350,000 per year

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442 Chapter 15

Before-tax CF $ 350,000
Less depreciation (107,143)
Income before tax $ 242,857
Less tax (25%) (60,714)
Net income $ 182,143
Add depreciation 107,143
After-tax cash flow $ 289,286
PV of 14 yr. annuity of $289,286 @ 10% $ 2,131,083
Less cost (1,500,000)
NPV $ 631,083
b. Discount factor = $1,500,000 $289,286 = 5.1852
Discount factor of 5.1852 corresponds to 17%.

c. Cash flow Discount factor = $1,500,000

Cash flow (7.3667) = $1,500,000
Cash flow = $203,619
d. $1,500,000 $289,286 = 5.1852
5.1852 is the discount factor for 10 percent and falls between the 10 percent
discount factors corresponding to seven and eight years.

54. a. Incremental annual after-tax cash flows:

Year 0
Purchase of new equipment $(300,000)
One-time transfer expense, net of tax ($80,000 0.6) (48,000)
Sale of old equipment, net of tax ($5,000 0.6) 3,000
Total initial cash outflow $(345,000)
ANNUAL OPERATIONS
Year 1 Year 2 Year 3 Year 4
Cash operating
savings $ 90,000 $150,000 $150,000 $150,000
Less tax effect (40%) (36,000) (60,000) (60,000) (60,000)
Cash savings after tax $ 54,000 $ 90,000 $ 90,000 $ 90,000
Depr. tax shield
(see sched. below) 48,000 36,000 24,000 12,000
After-tax operating
cash flows $102,000 $126,000 $114,000 $102,000
Depreciation Schedule
Depreciable Base: $300,000
Life: Four-Year Limit
Method: Sum-of-the-Years-Digits
Year Rate Depreciation Depr. Shield
1 4/10 $120,000 $48,000
2 3/10 90,000 36,000
3 2/10 60,000 24,000

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Chapter 15 443

4 1/10 30,000 12,000

b. The company should reject the proposal since the NPV is negative.
Year Cash Flow 11% PV Factor Present Value
0 $(345,000) 1.0000 $(345,000)
1 102,000 0.9009 91,892
2 126,000 0.8116 102,262
3 114,000 0.7312 83,357
4 102,000 0.6587 67,187
NPV $ (302)
(CMA adapted)

55. a. The benefits of a postinvestment audit program for capital expenditure projects in-
clude:

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

ing expected performance, to take any necessary corrective action, or to
terminate a project not achieving expected performance.
Evaluation of the accuracy of projections from different departments.
Improvement of future capital project revenue and cost estimates by analyz-
ing variations between expected and actual results from previous projects.
Motivational effect on personnel arising from the knowledge that a post-
investment 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 en-
vironment.
Identifying the impact of inflation on all costs in the capital project justifica-
tion.
Updating the original proposal for approval of changes that may have oc-
curred 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 post-investment
audit.
(CMA adapted)

56. a. Year Revenue VC FC Net Cash Flow

14 $115,000 $ 69,000 $20,000 $26,000
58 175,000 105,000 20,000 50,000
910 100,000 60,000 20,000 20,000

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444 Chapter 15

Year Cash Flow PV Factor PV

0 $(140,000) 1.0000 $(140,000)
14 26,000 3.1699 82,417
58 50,000 2.1651 108,255
910 20,000 0.8096 16,192
10 10,000 0.3855 3,855
NPV $ 70,719
b. Year Revenue VC FC Net Cash Flow
14 $120,000 $ 78,000 $15,000 $27,000
58 200,000 130,000 17,500 52,500
910 103,000 66,950 25,000 11,050
Year Cash Flow PV Factor PV
0 $(127,500) 1.0000 $(127,500)
14 27,000 3.1699 85,587
58 52,500 2.1651 113,668
910 11,050 0.8096 8,946
10 23,500 0.3855 9,059
NPV $ 89,760
c. The biggest factors are the increased level of variable costs, additional working
capital, lower initial revenues, and lower cost of production equipment.

57. a. Cash Cash Net Cumulative

Year Receipts Expenses Inflows Cash Flows
1 $3,000,000 $2,530,000 $ 470,000 $ 470,000
2 3,200,000 2,400,000 800,000 1,270,000
3 3,720,000 2,582,000 1,138,000 2,408,000
4 5,120,000 3,232,000 1,888,000 4,296,000
5 6,400,000 3,520,000 2,880,000 7,176,000
Payback = 4 + [($6,400,000 $4,296,000) $2,880,000] = 4.7 years
b. Year Cash Flow PV Factor PV
0 $(6,400,000) 1.0000 $(6,400,000)
1 470,000 0.9259 435,173
2 800,000 0.8573 685,840
3 1,138,000 0.7938 903,344
4 1,888,000 0.7350 1,387,680
5 2,880,000 0.6806 1,960,128
6 2,880,000 0.6302 1,814,976
7 1,632,000 0.5835 952,272
8 648,000 0.5403 350,114
NPV $ 2,089,527

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Chapter 15 445

c. Year Net Income

1 $ (330,000)
2 0
3 338,000
4 1,088,000
5 2,080,000
6 2,080,000
7 832,000
8 (152,000)
$ 5,936,000
Average annual income = $5,936,000 8 = $742,000
Average investment = (Cost + Salvage) 2
= ($6,400,000 + $0) 2 = $3,200,000
ARR = $742,000 $3,200,000 = 23.2%
d. Although there are no stated evaluation criteria for accounting rate of return or
payback, the NPV criterion meets the standard threshold of $0. Therefore, the
product line should be added.

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

Annual cash flow:
Additional revenue ($1.20 220,000) $264,000
Labor savings ($160,000 $100,000) 60,000
Other operating savings ($192,000 $80,000) 112,000
Total $436,000
NPV = $(1,120,000) + ($436,000 6.1446) = $1,559,046
b. Discount factor = $1,120,000 $436,000 = 2.5688
The IRR exceeds numbers reported in the present value appendix. By computer,
the IRR is found to be 37 percent.
c. $1,120,000 $436,000 = 2.6 years
d. ARR = ($436,000 $62,000) [($1,120,000 + $0) 2] = 66.8%
e. Because the project generates a very high NPV and IRR, as well as a high ARR,
the firm should buy the new lathe.
(CMA adapted)

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