170Chapter 15 CHAPTER 15CAPITAL BUDGETINGQUESTIONS1. A capital asset is a long-lived asset acquired by a firm. Capital assets providethe essential production and distributional capabilities required by allorganizations.2. Cash flows are the focus of capital budgeting investments just as cash flowsare the focus of any investment. Accounting income ultimately becomes cash flowbut is reported based on accruals, deferrals, and other accounting assumptions andconventions. These accounting practices and assumptions detract from the purityof cash flows and, therefore, are not used in capital budgeting.3. Time lines provide clear visual models of a projects expected cash inflows andoutflows for each point in time. These graphics provide an efficient and effectivemeans to help organize the information needed to perform capital budgeting analyses.4. Thepaybackmethodmeasures thetime expectedfor afirmtorecover itsinvestment in a project. The method ignores the receipts expected to occur after theinvestment is recovered and ignores the time value of money.5. Returnofcapital means the investor is receiving the principal that wasoriginally invested. Return oncapital means the investor is receiving an amountearned 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 valueofall cashoutflowsassociatedwiththeproject. IfNPViszero, theproject isacceptable 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 ofcapital.7. It is highly unlikely that the estimated NPV will exactly equal the actual NPVachieved because of the number of estimates necessary in the originalcomputation. These estimates include project life and timing and amounts of cashinflows and outflows. The original investment may also include an estimate of theamount of working capital needed at the beginning of the project life.8. Theprofitabilityindex(PI) is calculatedbydividingthediscountedcashinflows by the initial investment. The NPV method subtracts the initial investmentfrom the discounted net cash inflows to arrive at the net present value. Thus, eachcomputation uses the same amounts in different ways. By measuring the expecteddollars of discounted cash inflows per dollar of project investment, PI attempts tomeasure the planned efficiency of the use of the money (i.e., output to input). A PI 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.171Chapter 15 equal to or greater than 1 is equivalent to a NPV equal to or greater than zero andindicates that the investment will provide an acceptable return on capital.9. The IRR is the rate that would cause the NPV of a project to equal zero. Aproject is considered potentially successful (all other factors being acceptable) ifthe calculated IRR equals or exceeds the companys cost of capital.10. The amount of depreciation for a year is one factor that helps determine theamount of cash outflow for income taxes. Therefore, although depreciation is nota cash flow item itself, it does affect the size of another item (income taxes) that isa 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. Ofthebest investmentsforall worthwhileactivities, inwhichonesshould the company invest?12. Risk is defined as the likely variability of an assets future returns. Aspects ofa 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 organizationAs riskincreases, it shouldbe takenintoconsiderationincapital budgetinganalysis throughraisingthediscount rate(or someother acceptablemethod)which, in turn, lowers the NPV of a project.13. In capital budgeting, sensitivity analysis is used todetermine 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 decision maker an indication of how much room there is forerror inestimates for input variables andwhichinput variables needspecialattention.14. Postinvestment audits are performed to determinewhether the realized return matches the expected return on a project.Postinvestment audits are typically performed at or near the end of a projects life.15. The time value of moneyrefers tothe concept thatmoney has time-based earnings power. Money can be loaned or invested to earn arate of return. Present value is always less than future value because of the timevalue of money. A future value must be discounted to determine its equivalent 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 15172(but smaller) present value. The discounting process strips away the imputed rateof return in future values, thus present values are less than future values.16. ARR = Average annual profits Average investmentUnlike 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. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.173Chapter 15 EXERCISES17. Investors are ultimately most interested in cash flows.Investors cannot spend accounting income; they can only spend the cash that isderived from their investment in the firm. Investors are interested in accountingearnings because they reveal information about present and future cash flows thatis not revealed in examining only cash flows. Hence, accounting earnings are onlyuseful to investors if those earnings help inform the investors about cash flows.18. Cash flowsPeriod:0 1 2 3 4 5(Purchase)Savings3,000,000900,000 900,000 900,000 900,000 900,000Accounting earningsPeriod:0 1 2 3 4 5Expense savings900,000 900,000 900,000 900,000 900,000Depreciation 600,000 600,000 600,000 600,000 600,000!ncrease in accounting earnings 300,000 300,000 300,000 300,000 300,00019. No solution provided.20. The main point made should be that stock prices reflect the firms expected futurecash flows discounted at an appropriate risk-adjusted discount rate. The risk-adjusteddiscount rate is a function of both the specific securitys risk and the prevailingmarket interest rates. As market interest rates change, the value of securities changealsoespecially those that have distant future cash flows that comprise a significantportion of the securitys value, e.g., growth stocks.21. a. Payback = $3,000,000 $600,000 per year = 5 yearsb. Year Amount Cumulative Amount1 $300,000 $300,0002 300,000 600,0003 300,000 900,0004 300,000 1,200,0005 300,000 1,500,0006 400,000 1,900,0007 400,000 2,300,0008 400,000 2,700,0009 400,000 3,100,00010 400,000 3,500,000The payback is eight years plus [(3,000,000 2,700,000) 400,000] or 8.75years. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151722! a. !nvest"ent # $1%0,000 & $1'0,000 # $320,000Year Amount Cumulative Amount1 $70,000 $ 70,0002 78,000148,0003 72,000220,0004 56,000276,0005 50,000326,0006 48,000374,0007 44,000418,000Payback = 4 years + [($320,000 $276,000) $50,000] = 4.9 yearsBasedonthepaybackcriterion, HoustonFashionsshouldnot invest intheproposed product line.b. Yes. Houston Fashions should also use a discounted cash flowtechnique so as to consider both the time value of money and the cash flowsthat occur after the payback period.Point in Time Cash Flows PV Factor Present Value0 $(1,800,000) 1.0000 $(1,800,000)1 280,000 0.8929 250,0122 280,000 0.7972 223,2163 340,000 0.7118 242,0124 340,000 0.6355 216,0705 340,000 0.5674 192,9166 288,800 0.5066 146,3067 288,800 0.4524 130,6538 288,800 0.4039 116,6469 260,000 0.3606 93,75610 260,000 0.3220 83,720NPV $ (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 = $100,000Point in Time Cash Flows PV Factor Present Value0$(500,000) 1.0000 $(500,000)18(20,000) 5.5348 (110,696)18100,000 5.5348553,480NPV $(57,216)b. Based on the NPV, this is not an acceptable investment.c. Other considerations would include whether refusing to produce thispart for the customer would cause a loss of other business from that customer. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.175Chapter 15 The company should also consider going back to the customer and asking for ahigher price that would cause the project to have a positive NPV. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 1517"25. PI = PV of cash inflows PV of cash outflows = ($18,000 + $240,000) $240,000 = 1.0826. a. PV of inflows: $91,000 6.4177 # $('%,011PV of investment: $600,000PI = $584,011 $600,000 = 0.97b. Cedar City Public Transportation should not add the bus route becausethe PI is less than 1.00.c. To be acceptable, a project must generate a PI of at least 1; a PI greaterthan 1 equates to an NPV > 0.27. a. PV = Discount factor Annual cash inflow$700,000 = Discount factor $144,000Discount factor = $700,000 $144,000 = 4.8611The 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 7percent.c. $700,000 = 5.9713 Annual cash flowAnnual cash flow = $700,000 5.9713Annual cash flow = $117,22728. a. PV = Discount factor Annual cash inflow$1,800,000 = Discount factor $300,000Discount factor = $1,800,000 $300,000 = 6.0000The 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 onthe perceived quality of the food that is processed by the new machinery. Anadditional 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 = $1,608,113NPV = $375,000 Discount factor (10%, 7 years) $1,608,113 = ($375,000 4.8684) $1,608,113 = $217,53730. a. Annual depreciation = $1,000,000 8 years = $125,000 per yearTax benefit = $125,000 0.30 = $37,500PV = $37,500 5.7466 = $215,498 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.177Chapter 15 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= 26,462Total $252,639*In the final year, the remaining undepreciated cost is expensed.c. The depreciation benefit computed in (b) exceeds that computed in (a) solelybecause of the time value of money. The depreciation method in (b) allows forfaster recapture of the cost; therefore, there is less discounting of the future cashflows.31. a. SLD = $18,000,000 8 years = $2,250,000 per yearBefore-tax CF $ 3,100,000Less depreciation (2,250,000)Before-tax NI $850,000Less tax (30%)(255,000)NI $595,000Add depreciation2,250,000After-tax CF $ 2,845,000Point in TimeCash Flows PV Factor Present Value0 $(18,000,000) 1.0000 $(18,000,000)182,845,000 6.463218,387,804NPV $387,804The project is acceptable because the NPV is positive.b.Years 1 and 2Years 38Before-tax CF $ 3,100,000 $3,100,000Less depreciation (4,140,000)(1,620,000)Before-tax NI $(1,040,000) $1,480,000Tax (tax benefit)(312,000)444,000After-tax NI $ (728,000) $1,036,000Add depreciation4,140,000 1,620,000After-tax CF$ 3,412,000 $2,656,000Point in TimeCash Flows PV Factor Present Value0 $(18,000,000) 1.0000 $(18,000,000)12 3,412,000 1.8594 6,344,27338 2,656,000 4.603812,227,693NPV$571,966 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 1517#The equipment investment is acceptable. Note, because of the more rapiddepreciation used in (b) relative to (a), the NPV is more positive in (b) than in(a). 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.17$Chapter 15 c. Before-tax CF $ 3,100,000Less depreciation (2,250,000)Before-tax NI $850,000Less tax (40%)(340,000)NI $510,000Add depreciation2,250,000After-tax CF $ 2,760,000Point in Time Cash Flows PV Factor Present Value0 $(18,000,000) 1.0000 $(18,000,000)182,760,000 6.463217,838,432NPV $ (161,568)The equipment investment is unacceptable because the NPV is negative.Years 1 and 2 Years 38Before-tax CF $ 3,100,000 $3,100,000Less depreciation4,140,000 1,620,000Before-tax NI $(1,040,000) $1,480,000Tax (tax benefit)(416,000)592,000After-tax NI $ (624,000) $ 888,000Add depreciation4,140,000 1,620,000After-tax CF $ 3,516,000 $2,508,000Point in Time Cash Flows PV Factor Present Value0 $(18,000,000) 1.0000 $(18,000,000)12 3,516,000 1.85946,537,65038 2,508,000 4.603811,546,330NPV $83,980The equipment investment is acceptable.32. a. Tax: $99,000 $18,000 = $81,000Financial accounting: $99,000 $35,000 = $64,000b. CFAT = Current market value Taxes = $37,000 [($37,000 $18,000) 0.30] = $31,300c. CFAT = $9,000 [($9,000 $18,000) 0.30] = $11,70033. a. paybackb. NPV, PIc. IRRd. payback, NPV, PI, IRRe. all methodsf. paybackg. ARR34. a. payback, NPV, PI, IRR 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151#0b. paybackc. ARRd. payback, ARRe. payback, NPV, PI, IRRf. all methodsg. IRRh. payback, IRR, ARR, PI35. a. Project Name NPV PIIRRFilm studios $3,578,910 1.1813.03%Cameras & equipment 1,067,920 1.33 18.62Land improvement 2,250,628 1.45 19.69Motion picture #1 1,040,276 1.06 12.26Motion picture #2 1,026,008 1.09 14.09Motion picture #3 3,197,320 1.40 21.32Corporate aircraft 518,916 1.22 18.15b. Ranking according to:NPV PI IRR1. FilmstudiosLand improvement MP #32. MP #3 MP #3 Land improvement3. Land improvementCameras & equip. Cameras & equip.4. Cameras &equip.Corp. aircraft Corp. aircraft5. MP #1 Film studios MP #26. MP #2 MP #2 Film studios7. Corp.aircraftMP #1 MP #1c. Suggested purchases: NPV 1. Motion picture #3 @$8,000,000$3,197,3202. Land improvement @$5,000,0002,250,6283. Cameras &equipment @$3,200,0001,067,9204. Corporate aircraft @$2,400,000 518,916Total NPV $7,034,78436. a. Cash flow Annuity factor = $160,000Cash flow 3.7908 = $160,000Cash flow = $42,207b. $160,000 $42,207 = 3.79 years 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1#1Chapter 15 37. a. NPV = ($28,000 4.8684) $100,000 = $36,315b. Annuity factor $28,000 = $100,000Annuity factor = $100,000 $28,000 = 3.5714This factor corresponds most closely to 20%38. PV = FV Discount factor$80,000 = FV 0.7473FV = $80,000 0.7473 = $107,05239. Cost = $8,000 + PV($800 annuity) = $8,000 + ($800 37.9740*) = $38,379.20*Discount factor for 48 months, 1% 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151#240. a. PV = Future value Discount factor= $50,000 0.6302= $31,510 should be invested to achieve the goalb. PV = Future value Discount factor= $400,000 0.3769= $150,760 would be equivalent todayc. PV = Future value Discount factor= $60,000 0.2146= $12,876d. Present value = Annuity Annuity discount factor= $200,000 3.9927= $798,540e. Year 1 receipt:$50,000 0.9346 =$46,730Year 2 receipt:$55,000 0.8734 =48,037Year 3 receipt:$60,000 0.8163 =48,978Year 4 receipt:$100,000 0.7629 =76,290Year 5 receipt:$100,000 0.7130 =71,300Year 6 receipt:$100,000 0.6663 =66,630Year 7 receipt:$100,000 0.6228 =62,280Year 8 receipt:$100,000 0.5820 =58,200Year 9 receipt:$70,000 0.5439 =38,073Year 10 receipt:$45,000 0.5084 =22,878Present value $539,396f. No. Using any discount rate above 0, the present value of the future annualcash flows is well below $1,000,000.41. a. Change in net income = $20,000,000 ($72,000,000 5) = $5,600,000ARR = $5,600,000 ($72,000,000 2) = 15.6%Payback = $72,000,000 $20,000,000 per year = 3.6 yearsb. No. Although the dredge meets the payback criterion, it fails to meet the ARRcriterion of 18 percent.42. a. Annual cash receipts $15,000Cash expenses (3,000)Net cash flow before taxes $12,000Depreciation(6,667)Income before tax $5,333Taxes(1,600)Net income $3,733Depreciation 6,667Annual after-tax cash flow $10,400 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1#3Chapter 15 b. Payback = $40,000 $10,400 per year = 3.8 yearsc. ARR = $3,733 ($40,000 2) = 18.7% 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151#PROBLE%S43. a. A lease is found appealing by consumers because it often results in a lowermonthlypayment thanthat whichwouldhavebeenrequiredtopurchaseaspecific car. Alternatively, the consumercould opt to "a)e the pay"entre*uired to purchase the +speci,ic- car but obtain a "ore e.pensive car underlease ,inancing.b. No. A consumer should be provided with all necessary information to make afair comparison between the lease and purchase alternative.c. As an accountant, you could provide a financial comparison of the lease andpurchase alternatives. Using a discounted cash flowapproach, you couldcomparethepresent valueofpurchasingthevehicletothepresent valueofleasing the vehicle.44. a. Although the 8 percent hurdle rate may be appropriate for most projects,itmaybeinappropriatetoinsist that aproject suchasapollutionabatementproject be required to meet any financial hurdle rate.b. Inthe future, the companycouldface not onlysignificant finesfromgovernment regulators, butalsofinancial claimsfiledbypersons harmed by the arsenic.c. Hernandez should justify the investment basedbothonthepotential futurefinancial claims andthat it is thesociallyandethically correct action for the company to take.45. a. ($000s omitted)t0t1t2t3t4t5t6t7t8Investment (190)New CM60 60 60 60 60 60 6060Oper. costs 0 20 27 27 27 30 30 30 33Cash flow (190) 40 33 33 33 30 30 30 27b. Year Cash Flow Cumulative Cash Flow1 $40,000 $ 40,0002 33,000 73,0003 33,000 106,0004 33,000 139,0005 30,000 169,0006 30,000 199,000Payback = 5 + [($190,000 $169,000) $30,000] = 5.7 years 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1#5Chapter 15 c. Time Cash Flow PV Factor for 8% Present Value0 $(190,000) 1.0000 $(190,000)1 40,000 0.9259 37,0362 33,000 0.8573 28,2913 33,000 0.7938 26,1954 33,000 0.7350 24,2555 30,000 0.6806 20,4186 30,000 0.6302 18,9067 30,000 0.5835 17,5058 27,000 0.540314,588NPV $ (2,806)46. a. Time:t0t1t2t3t4t5t6t7Amount:($41,000) $5,900 $8,100 $8,300 $8,000 $8,000 $8,300 $9,200b. YearCash 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 46,600Payback = 5 years + [($41,000 $38,300) $8,300] = 5.3 yearsc. Cash Flow Discount PresentDescription Time Amount Factor ValuePurchase the truck t0 $(41,000) 1.0000 $(41,000)Cost savings t15,900 0.9259 5,463Cost savings t28,100 0.8573 6,944Cost savings t38,300 0.7938 6,589Cost savings t48,000 0.7350 5,880Cost savings t58,000 0.6806 5,445Cost savings t68,300 0.6302 5,231Cost savings t79,200 0.5835 5,368NPV $ (80)47. a. YearCash Flow PV Factor PV0 $(5,000,000) 1.0000 $(5,000,000)17 838,000 5.5824 4,678,0517 400,000 0.6651 266,040NPV $ (55,909)b. No, the NPV is negative; therefore this is an unacceptable project. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151#"c. PI = ($4,678,051 + $266,040) $5,000,000 = 0.99d. PV of annual cash flows = $5,000,000 $266,040PV of annual cash flows = $4,733,960PV 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= $960,015e. The company should consider the quality of work performed by the machinecompared to the quality of work performed by the individuals; the reliability ofthemechanical processcomparedtothemanual process; andperhapsmostimportantly, theeffect onworker morale andtheethical considerations indisplacing 14 workers.48. a. Payback period = $140,000 ($47,500 $8,500) = 3.6 yearsThe project does not meet the payback criterion.b. Discount factor = Investment Annual cash flow= $140,000 $39,000 = 3.5897Discount 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 systemon tax return accuracy and quality of service delivered to clients and (2) theeffect of firing one employee on both the dismissed employee and theremaining employees.49. a. The incremental cost of the replacement equipment: $580,000 $12,000 = $568,000Cash Flow Discount PresentDescription Time Amount Factor ValueIncremental cost t0 $(568,000) 1.0000 $(568,000)Cost savings t1 t8 120,000 5.3349640,188NPV $ 72,188PI = $640,188 $568,000 = 1.1Yes, the replacement equipment should be purchased because the NPV > 0 andthe PI > 1. 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1#7Chapter 15 b. Payback = $568,000 120,000 per year = 4.7 yearsc. Net investment Annual annuity = Discount factor of IRR$568,000 120,000 = 4.7333Discount factor of 4.7333 is between 13.0 and 13.5 percent; therefore, to thenearest whole percent, the IRR is 13 percent.50. a. Computation of net annual cash flow:Increase in revenues $ 46,000Increase in cash expenses (21,000)Increase in pre-tax cash flow $ 25,000Less depreciation(9,750)Income before tax $ 15,250Income taxes (30 percent)(4,575)Net income $ 10,675Add depreciation9,750After-tax cash flow $ 20,425Cash Flow DiscountPresentDescriptionTime Amount FactorValueInitial costt0$(195,000) 1.0000 $(195,000)Annual cash flowt1 t20 20,425 9.1286186,452NPV $(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 = $195,000Minimum annual after tax cash flow 9.1286 = $195,000Minimum 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 $30,750Minimum cash revenues = $47,337Proof: Computation of net annual cash flow: Increase in revenues $ 47,337Increase in cash expenses (21,000)Increase in pre-tax cash flow $ 26,337Less depreciation(9,750)Income before tax $ 16,587Income taxes (30 percent)(4,976)Net income $ 11,611Add depreciation9,750After-tax cash flow $ 21,361 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151##51. a. Cash flow after tax (CFAT):Year Pre-Tax CF Depreciation Tax CFAT1 $104,000 $64,000 $14,000 $ 90,0002118,000 102,400 5,460 112,5403118,000 60,800 20,020 97,9804102,000 48,000 18,900 83,100586,000 44,800 14,420 71,580Timeline: t0t1t2t3t4t5$(320,000) $90,000 $112,540 $97,980 $83,100 $71,580b. Year Net Cash Flow Cumulative Cash Flow1 $ 90,000$90,0002 112,540202,5403 97,980300,5204 83,100383,620Payback = 3 years + [($320,000 $300,520) $83,100] = 3.2 yearsNet present value:TimeAmount Discount Factor Present Value0$(320,000) 1.0000$(320,000)1 90,000 0.9259 83,3312 112,540 0.8573 96,4813 97,980 0.7938 77,7774 83,100 0.7350 61,0795 71,580 0.6806 48,717NPV $47,385Profitability index = ($320,000 + $47,385) $320,000 = 1.1IRR is 14 percent.52. a. Maple Commercial Plaza:t0t1 t10 t10$(800,000)$210,000 $400,000High Tower: t0t1 t10 t10$(3,400,000) $830,000 $1,500,000b. Maple Commercial Plaza:Calculation of annual cash flow:Pre-tax cost savings $210,000Depreciation ($800,000 25)(32,000)Pre-tax income $178,000 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1#$Chapter 15 Taxes (40 percent)(71,200)After-tax income $106,800Depreciation 32,000After-tax cash flow $138,800t0t1 t10t10$(800,000) $138,800 $432,000**Includes $32,000 from tax loss on sale [0.40 ($400,000 $480,000)] 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151$0High Tower:Calculation of annual cash flow:Pre-tax cost savings $ 830,000Depreciation ($3,400,000 25)(136,000)Pre-tax income $ 694,000Taxes(277,600)After-tax income $ 416,400Depreciation136,000After-tax cash flow $ 552,400t0 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 Value0 $(800,000) 1.0000 $(800,000)110138,800 5.8892 817,42110432,000 0.3522 152,150NPV $ 169,571After-tax NPV, Hightower:Year Amount Discount Factor Present Value0 $(3,400,000) 1.0000 $(3,400,000)110552,400 5.8892 3,253,194101,716,000 0.3522 604,375NPV $457,569 Based on the NPV criterion, Hightower is the preferred investment.d. After-tax NPV, Hightower:Year Amount Discount Factor Present Value0$(3,400,000) 1.0000 $(3,400,000)110 180,400 5.8892 1,062,412110 372,000* 4.1925 1,559,61010 1,716,000 0.3522 604,375 NPV $ (173,603)*Rental portion of cash flow = $620,000 (1 Tax rate)= $620,000 0.60= $372,000In this circumstance, Maple Commercial Plaza is the preferred investment.53. a. Depreciation per year = $1,500,000 14 = $107,143Before tax cash flows = [300 0.80 ($70 $20) 50] $250,000= $350,000 per year 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1$1Chapter 15 Before-tax CF$ 350,000Less depreciation(107,143)Income before tax $ 242,857Less tax (25%) (60,714)Net income $ 182,143Add depreciation107,143After-tax cash flow $ 289,286PV of 14 yr. annuity of $289,286 @ 10% $ 2,131,083Less cost (1,500,000)NPV $631,083b. Discount factor = $1,500,000 $289,286 = 5.1852Discount factor of 5.1852 corresponds to 17%.c. Cash flow Discount factor = $1,500,000Cash flow (7.3667) = $1,500,000Cash flow = $203,619d. $1,500,000 $289,286 = 5.18525.1852 is the discount factor for 10 percent and falls between the 10 percentdiscount factors corresponding to seven and eight years.54. a. Incremental annual after-tax cash flows:Year 0Purchase 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)3,000Total initial cash outflow $(345,000)ANNUAL OPERATIONSYear 1Year 2Year 3 Year 4Cash operatingsavings $90,000 $150,000 $150,000 $150,000Less tax effect (40%)(36,000) (60,000)(60,000) (60,000)Cash savings after tax $54,000 $90,000 $90,000 $90,000Depr. tax shield(see sched. below) 48,000 36,000 24,000 12,000After-tax operatingcash flows $102,000 $126,000 $114,000 $102,000Depreciation ScheduleDepreciable Base: $300,000Life: Four-Year LimitMethod: Sum-of-the-Years-Digits 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151$2 Year Rate DepreciationDepr. Shield1 4/10 $120,000 $48,0002 3/10 90,000 36,0003 2/10 60,000 24,0004 1/10 30,000 12,000b. The company should reject the proposal since the NPV is negative.Year Cash Flow 11% PV FactorPresent Value0$(345,000) 1.0000 $(345,000)1 102,000 0.9009 91,8922 126,000 0.8116 102,2623 114,000 0.7312 83,3574 102,000 0.658767,187NPV $(302) (CMA adapted)55. a. The benefits of a postinvestment audit program for capital expenditure projectsinclude: Comparisonof actual andprojectedresults tovalidatethat aproject ismeeting expected performance, to take any necessary corrective action, orto 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 byanalyzingvariations betweenexpectedandactual results frompreviousprojects. Motivationaleffect onpersonnelarisingfromtheknowledgethat apost-investment audit will be done.b. Practical difficulties that would be encountered in collectingand accumulating information include: Isolating the incremental changes caused by one capital project from all theother factors that changeinadynamicmanufacturingand/or marketingenvironment. Identifying the impact of inflation on all costs in the capital projectjustification. Updatingthe original proposal for approval of changes that mayhaveoccurred after the initial approval. Havinga sufficientlysophisticatedinformationaccumulationsystemtomeasure actual costs incurred by the capital project. Allocating sufficient administrative time and expenses for the post-investmentaudit. (CMA adapted)56. a. Year Revenue VC FC Net Cash Flow14 $115,000 $ 69,000 $20,000 $26,00058 175,000 105,000 20,000 50,000 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1$3Chapter 15 910 100,000 60,000 20,000 20,000 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.Chapter 151$Year Cash Flow PV FactorPV 0 $(140,000) 1.0000$(140,000)14 26,000 3.1699 82,41758 50,000 2.1651 108,255910 20,000 0.8096 16,19210 10,000 0.38553,855NPV$ 70,719b. YearRevenue VCFCNet Cash Flow14 $120,000 $ 78,000 $15,000 $27,00058 200,000 130,000 17,500 52,500910 103,000 66,950 25,000 11,050Year Cash Flow PV Factor PV0 $(127,500) 1.0000$(127,500)14 27,000 3.1699 85,58758 52,500 2.1651 113,668910 11,050 0.8096 8,94610 23,500 0.38559,059NPV $89,760c. The biggest factors are the increased level of variable costs,additional working capital, lower initial revenues, and lower cost of productionequipment.57. a. Cash Cash Net CumulativeYear Receipts Expenses Inflows Cash Flows1 $3,000,000 $2,530,000 $ 470,000 $ 470,0002 3,200,000 2,400,000 800,000 1,270,0003 3,720,000 2,582,000 1,138,000 2,408,0004 5,120,000 3,232,000 1,888,000 4,296,0005 6,400,000 3,520,000 2,880,000 7,176,000Payback = 4 + [($6,400,000 $4,296,000) $2,880,000] = 4.7 yearsb. Year Cash FlowPV Factor PV0 $(6,400,000) 1.0000 $(6,400,000)1 470,000 0.9259 435,1732 800,000 0.8573 685,8403 1,138,000 0.7938 903,3444 1,888,000 0.7350 1,387,6805 2,880,000 0.6806 1,960,1286 2,880,000 0.6302 1,814,9767 1,632,000 0.5835 952,2728 648,000 0.5403350,114NPV $2,089,527 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.1$5Chapter 15 c.Year Net Income1$ (330,000)2 03 338,0004 1,088,0005 2,080,0006 2,080,0007 832,0008(152,000) $ 5,936,000Average annual income = $5,936,000 8 = $742,000Average investment = (Cost + Salvage) 2 = ($6,400,000 + $0) 2 = $3,200,000ARR = $742,000 $3,200,000 = 23.2%d. Although there are no stated evaluation criteria foraccountingrateofreturnor payback, theNPVcriterionmeetsthestandardthreshold 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)$264,000Labor savings /$100,000 $100,0001 60,000Other operating savings ($192,000 $80,000) 112,000Total $436,000NPV = $(1,120,000) + ($436,000 6.1446) = $1,559,046b. Discount factor = $1,120,000 $436,000 = 2.5688The 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 yearsd. ARR =($436,000 $62,000) [($1,120,000+$0)2] =66.8%e. Because the project generates a very high NPV and IRR, aswell as a high ARR, the firm should buy the new lathe.(CMA adapted) 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible ebsite, in hole or in part.