chapter 26- capital budgeting

5/21/2018 Chapter 26- Capital Budgeting

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CHAPTER 26

CAPITAL BUDGETINGe on

Brief LearningExercises Topic Objectives Skills

B. Ex. 26.1 Understanding payback period 3 Analysis

B. Ex. 26.2 Use of return on investment 3 Analysis

B. Ex. 26.3 Comparing NPV and required rate of return 3, 4 Analysis

B. Ex. 26.4 Net present value computations 3 Analysis

B. Ex. 26.5 Computations for payback period 3 Analysis

B. Ex. 26.6 Capital investment challenges 1, 2 Analysis, judgment

B. Ex. 26.7 Net present value and required rate of return 3, 4 Analysis, judgment

B. Ex. 26.8 Capital budgeting behaviors 5 Analysis, judgment

B. Ex. 26.9 Net present value analysis 3 Analysis

B. Ex. 26.10 Nonfinancial investment concerns 2 Analysis, communication,

judgment

Learning

Exercises Topic Objectives Skills

26.1 Accounting terminology 15 Analysis

26.2 Payback period 13 Analysis, communication,

judgment

26.3 Understanding return on average investment 1, 3 Analysis26.4 Discounting cash flows 3 Analysis

26.5 Understanding net present value 3 Analysis

26.6 Analyzing a capital investment proposal 1, 3 Analysis

26.7 Analyzing capital investment proposal 14 Analysis, communication,

judgment

26.8 Analyzing capital investment proposal 1, 3 Analysis

26.9 Competing investment proposals 1, 2, 5 Analysis, communication,

judgment

26.10 Replacing existing equipment 13, 5 Analysis, communication,

judgment

26.11 Gains and losses on sale of equipment 3 Analysis

26.12 Depreciation effects on cash flows 3 Analysis

OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL

THINKING CASES

The McGraw-Hill Companies, Inc., 2010

CH26-Overview


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Learning

Exercises Topic Objectives Skills

26.13 Net present value in a not-for-profit 2, 3 Analysis, communication,

judgment

26.14 NPV of uneven cash flows 3 Analysis

26.15 Real World: Home Depots present value of

store closing costs

13 Analysis, communication,

judgment , research

Problems Learning

Sets A, B Topic Objectives Skills

26.1 A,B Capital budgeting and determination of

annual net cash flow

14 Analysis

26.2 A,B Analyzing capital investment proposals 14 Analysis, judgment,

communication

26.3 A,B Analyzing capital investment proposals 14 Analysis, judgment,

communication

26.4 A,B Capital budgeting using multiple models 14 Analysis, judgment,

communication

26.5 A,B Capital budgeting using multiple models 14 Analysis, communication,

judgment

26.6 A,B Analyzing a capital investment proposal 3 Analysis

26.7 A,B Considering financial and nonfinancial

factors


judgment

26.8 A,B Analyzing competing capital investment

proposals


judgment

26.9 A,B Analyzing competing capital investment

proposals


judgment

Critical Thinking Cases

26.1 How much is that laser in the window? 24 Analysis, communication,

judgment

26.2 Dollars and cents versus a sense of ethics 15 Analysis, communication,

research

26.3 International investments in outsourcing 1, 2, 5 Analysis, communication,

(Business Week) judgment

26.4 Real World: Sears 1, 2, 5 Analysis, communication

Capital investment history judgment, research,

(Internet) technology

26.5 Real World: Red Robin Gourmet 5 Analysis, communication

Burgers judgment

(Ethics, fraud and corporate governance)


CH26-Overview (p.2)


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DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES

Problems (Sets A and B) 26.1 A,B Toying with Nature/Monster Toys 30 Strong

Covers incremental analysis and three basic capital budgeting

techniques in a single problem.

26.2 A,B Micro Technology/Macro Technology 25 Medium

Basic capital budgeting. Compute the payback period, return on average

investment, and net present value of two investment alternatives.

Student must decide which investment to select.

26.3 A,B Banner Equipment Co./Flagg Equipment Co. 25 Medium

Basic capital budgeting. Compute the payback period, return on averageinvestment, and net present value of two investment alternatives.


26.4 A,B Marengo/Tango 25 Medium




26.5 A,B V.S. Yogurt/I.C. Cream 25 Medium




26.6 A,B Rothmore Appliance Company/Cafield Appliance Company 30 Strong

Prepare a schedule showing the estimated incremental net income from

proposed introduction of a new product. Compute annual cash flow,

payback period, return on average investment, and net present value of

the investment proposal.

26.7 A,B Doctors 40 Strong

Students must determine whether it is profitable for several doctors toinvest their money in an expensive piece of testing equipment. Requires

financial analysis and consideration of nonfinancial aspects of their

decision.

Below are brief descriptions of each problem and case. These descriptions are accompanied by the

estimated time (in minutes) required for completion and by a difficulty rating. The time estimates

assume use of the partially filled-in working papers.


Description of Problems


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26.8 A,B Jefferson Mountain/Madison Mountain 50 Strong

A small ski resort must decide between alternative investment

proposals. Students are asked to analyze financial and nonfinancial

considerations relevant to the decision.

26.9 A,B Sonic, Inc./Boom, Inc. 45 Strong

A software company is trying to decide how to market their software.Students are asked to analyze financial and nonfinancial

considerations relevant to the decision.


Desc. of Problems (p.2)


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Critical Thinking Cases

26.1 The Case of the Costly Laser 25

Compute the net present value of a proposal to replace existing

equipment with new, more efficient equipment. The sale of the existing

equipment will involve a large loss. Students are asked to comment on

the relevance of this sunk cost.

26.2 Grizzly Community Hospital 60

A small community hospital considers a major capital investment in a

regional kidney center. Students are asked to analyze financial and

nonfinancial information relevant to the decision, explore alternative

uses of resources, and help the hospital define its role.

26.3 International Investments in Outsourcing 20

Business Week

The cash flows associated with offshore investments are identified.

Ethical considerations of asking domestic employees to train their

international replacements are considered.

26.4 Sears, Roebuck and Company 25

Internet

This assignment requires students to review a short history of Sears and

identify major capital investment decisions made by the company since

its inception in the late 1800s. For one such decision, nonfinancial

considerations are to be discussed.

26.5 Goverance and Capital Budgeting Conflicts 30

Ethics, Fraud & Corporate Governance

Governance violations at Red Robin Gourmet Burgers leads to capital

budgeting conflicts of interest.


Desc. of Cases


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Strong

Strong

Medium

Easy

Medium


Desc. of Cases


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SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1.

2.

3.

4.

5.

6.

7.

8.

In appraising the adequacy of a rate of return, an investor should consider the cost of investment

capital, the rates of return available on alternative investment opportunities, the risk associated

with realizing the estimated rates of return, and the nonfinancial aspects of this and other

investment opportunities.

Capital budgetingis the process of planning and evaluating investments in plant assets. Capital

budgeting decisions are crucial to the long-run financial health of a business enterprise because

large amounts of funds are committed for long periods of time. Also, capital budgeting decisions

often are difficult to reverse once the funds have been committed.

Corporate management would allow a lower rate of return for newly developing divisions, when

there is a strategic necessity to penetrate a new market, or when acquiring a new technology

where cash flow estimation is extremely difficult.

The major shortcoming in using the payback period as the sole criterion in capital budgeting

decisions is that this method ignores the totallife and, therefore, the total profitability and total

cash flow to be derived from the investment.

The present value of a future amount is the amount of money which, if invested today to earn a

return equal to the discount rate, would become equivalent to the future amount at the future

date. Less money needs to be invested to grow to a specified amount if that investment will earn

a 15% return than if it will earn only 10%.

The present value of a future cash flow is dependent upon (1) the amount of the future cash flow,

(2) the length of time until that cash flow will occur, and (3) the discount rate used to reduce the

future cash flow to its present value.

Discounting cash flows takes into consideration the timingof the earnings stream. The return on

average investment is based upon average annual earnings and, therefore, does not distinguish

between income received early or late in the life of the investment. Discounting cash flows

recognizes the time value of moneythe economic fact that receiving a given cash flow in the

near future is preferable to receiving the same cash flow in the more distant future.

Nonfinancial considerations associated with the installation of a fire sprinkler system may

include (1) an ethical responsibility to provide safe working conditions, (2) compliance with

federal and/or state safety standards, and (3) reducing the risk of having inventory destroyed by

fire.


Q1-8


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9.

10.

11.

12.

13.

14. Although depreciation expense does not require a payment in cash, it is an important

consideration in the discounting of an investments future cash flows because of its income

tax consequences.

Timing differences are very important in present value computations and projects that have

more significant cash inflows after several years will inevitably have lower present values

than projects with significant cash inflows in the immediate years after the investment has

been made. To consider this difference, consider making an investment in an existing

McDonalds that is well established with a current stream of positive net cash flows. Now

consider starting a new business with a franchise that is not as well known. The new business

will require construction before it even opens, delaying cash flows. Even after it is open it will

take significant time to build up a steady clientele. These differences in timing of cash flows

can make purchasing an existing business with a strong brand a more attractive (and as a result

a more expensive) alternative.

If an investment with no salvage value has a payback period that exceeds its estimated life, the

investments net present value will be negative. If the payback period exceeds the assets life,

the total cash flows generated by the investment will be less than the initial cost of the

investment. Thus, the discounted present value of those cash flows must also be less than the

initial cost of the investment, making its net present value negative.

If an investment proposal has a net present value of zero, the expected rate of return is equal to

the discount rate.

Factors to consider in establishing a minimum required return on an investment proposal may

include (1) the companys cost of capital, (2) the relative risk of the investment, (3) returns

associated with alternative investment proposals, (4) the expected life of the investment, (5)

the investments impact on keeping the company competitive, (6) how quickly the technology

associated with the investment is changing, and (7) nonfinancial considerations such as ethical

and legal issues.

An investments contribution to income is not the same as its incremental cash flow because

income is not defined as net cash flow. In an accrual-based accounting system, revenues are

recognized when earned, not when cash is received. In addition, expenses are recognized when

incurred, not when cash is disbursed.


Q9-14


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15.

16.

17.

18.

19.

20.

One way to ensure that employee estimates of the costs and benefits of capital investments are

not overly optimistic or pessimistic is to implement a system for auditing capital budget

decisions. With an audit system in place, employees will be aware that their estimates will be

checked against actual results, and any biases discovered. Another step firms can take is to use

routing forms, where several high-level managers must sign off on a capital expenditure. Each

manager then has the opportunity to question or verify the estimates. Employees will be less

likely to bias estimates if they know they will be scrutinized by several managers. Finally, a

firm may employ a neutral third party to provide a second set of estimates. If there are large

discrepancies between the two estimates, further investigation can be undertaken.

If a company is replacing an asset, the first income tax consequence to be considered is

whether the old asset will be sold at a gain or a loss (a loss is most likely). A loss can be

immediately deducted on the tax return instead of deducting it over the remaining life of the

asset. Income taxes will also be affected by a difference in operating expenses and deductions

for depreciation due to the new asset.

A manager prefers the investment opportunity that has the lowest risk, the shortest paybackperiod, and the highest rate of return.

The discount rate is equivalent to the rate of return required by an investor. This is important

because an investor wants a project to cost less than the present value of its future cash flows.

In order for this to be accomplished, the expected rate of return exceeds the required rate of

return.

Some capital investment proposals which may favor nonfinancial factors include a pollution

control systems, new factory lighting, an employee health club, and an employee child care

facility. When deciding whether to undertake any of these projects, many nonfinancial

considerations come into play such as environmental concern, employee morale, flexibility,

better working conditions, etc.

Employees are going to be affected by any capital budgeting decisions a firm makes.

Therefore, employees who make estimates regarding proposals may inflate or deflate

estimates based on how the investment would affect the employee. Also, estimates come from

a variety of sources and there is always possibility of error.


Q15-20


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B. Ex. 26.1 The payback period is computed as follows:

Amount Invested

Annual Net Cash Flow

B. Ex. 26.2 Proposal 1:

Average investment = (Original cost + salvage value) 2

($115,000 + $11,000) 2 = $63,000

ROI = (Average estimated net income average investment)

$13,000 $63,000 = 20.6%

Proposal 2:

Average investment = (Original cost + salvage value) 2

($93,000 + $5,000) 2 = $49,000

ROI = (Average estimated net income average investment)

$10,500 $49,000 = 21.4%

B. Ex. 26.3

B. Ex. 26.4 Present value of expected annual cash flows ($19,000 4.111) 78,109$

Present value of proceeds from disposal ($2,000 .507) 1,014

Total present value of investments future cash flows 79,123

Cost of investment (56,000)

Net present value of proposed investment 23,123$

B. Ex. 26.5 Amount to be invested $45,650

Est. annual net cash flows $11,000

B. Ex. 26.6

$100,000

$10,000 + $5,000

SOLUTIONS TO BRIEF EXERCISES

= = 4.15 years

Replacement equipment is typically among the easiest for which to estimate cash

flows primarily because the company has experience with similar types of

equipment. Thus, replacing a fleet of trucks, where 20% of the fleet is replaced

each year so that over a five year period all trucks have been replaced, is the type

of investment that is easy to estimate cash flows.

= =or 6 years 8 months.

6 2/3 years

If the investment proposal has a positive net present value of $20 when an 8%

discount rate is used, its actual rate of return must be slightly above 8%. Because

its net present value is a negative $2,000 when a 10% discount rate is used, we

may conclude that the investments actual rate of return is less than 10%, and

very close to 8%.


BE26.1,2,3,4,5,6


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B. Ex. 26.7

B. Ex. 26.8

B. Ex. 26.9 Present value of expected annual cash savings ( X 3.791) = ???

Present value of proceeds from disposal ($150,000 .621) = 93,150$

Total Present Value of investments future cash flows 350,000$

Cost of investment 350,000$

Net present value of proposed investment 0

Thus, the expected annual cash savings:

X = ($350,000 - $93,150) 3.791 = $67,753

B. Ex. 26.10

If the initial outlay for the project is $125,000 and the net present value of the

future cash flows is $120,000, then the present value (based on the 12% required

rate of return) of the salvage value must be equal to at least $5,000. The salvage

value is $10,000 in 10 years. The discount rate from the table is .322. Thus the

present value of $10,000 at 12% over 10 years is $3,220. This is below the $5,000

needed to have a net present value of 0 for the project. Thus the projects rate of

return must be below 12%.

The net present value cash flows could be optimistic because the outside salesperson was optimistic about the value added of the new equipment and Ron was

optimistic about the new equipment. Ron obviously likes more satisfied

employees. However, how that satisfaction can be translated into higher cash

flows is uncertain.

Sams should also consider the potential cannibalization of in-store sales, the

possible additional advertising that is available from on-line activities, the

potential to reach a national customer base, the need for distribution services,

the need for return services, quality issues when shipping is not under Sam's

control, etc. Students will have many answers.

Alternatively, new technology is inherently difficult to estimate. For example,

when VCRs, DVD players, or I-Pods were first introduced to the market, the

prices were set fairly high because manufacturers could not estimate demand. As

demand grew and as the company moved further down its learning curve and

achieved economies of scale, then prices fell. Estimating demand for new

technologies and products is extremely difficult. The net present value of

investment in R&D is very difficult to estimate. The nonfinancial characteristics

that differ are mostly about uncertainty.


BE26.7,8,9,10


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BE26.7,8,9,10


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SOLUTIONS TO EXERCISES

Ex. 26.1 a.

b.

c.

d.

e.

f.

g.

h.

i.

Ex. 26.2 a.

$27,000

$6,000*

b.

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

c. Based strictly on payback periods, the Toledo Tools machine is more attractive

because its cost will be recovered one year sooner than the cost of the Akron

Industries machine. However, the payback period should never be the only

factor used to evaluate an investment decision because it ignores the

profitability of an investment over its total life, it ignores the discounted

present values of the investments future cash flows, and it ignores important

nonfinancial considerations.

If the Akron Industries machine has a payback period of 66 months (or 5.5

years), its cost can be computed as follows:

= 5.5 years

$26,000 - $20,000 = $6,000

27,000 - 21,000 = 6,000

32,000 - 26,000 = 6,000

35,000 - 29,000 = 6,000

34,000 - 28,000 = 6,000

Incremental analysis

Sunk cost

Capital budgeting

Return on average investment

Salvage value

The payback period for the Toledo Tools machine is computed as follows:

Estimated Annual Net Cash $6,000*

Payback period

None (This statement describes the amount to be subtracted from an assets

initial cost in determining its net present value.)

Present value

Discount rate

Amount to Be Invested

= = 4.5 yearsEstimated Annual Net Cash

33,000 - 27,000 = 6,000

Cost = $6,000 5.5 years = $33,000

*The estimated annual net cash flow of both investments:

Amount to Be Invested=

Cost


E26.1,2


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Ex. 26.3

Original Cost + Salvage

2Average Investment =

= 20%

Average Investment = $3,400 20% = $17,000

Thus, the estimated salvage value of I nvestment Cis:

= $25,000

= 25%$6,000

$24,000

I nvestment B

Thus, the average estimated net income of I nvestment Bis:

=Average Investment

Salvage Value = ($17,000 2) $25,000 = $9,000

$25,000 + $ ?

2Average Investment =

Average Estimated Net Income = 32% $25,000 = $8,000

I nvestment C

The average investment of I nvestment Cis:

Average Estimated Net Income = 3400Average Investment $ ?

$25,000= 32%

Average Estimated Net Income=

Average Investment =$45,000 + $5,000

2

Average Investment

$ ?

Original Cost + Salvage

2

The missing data for each investment proposal are solved for as follows:

I nvestment A

Average Investment =Original Cost + Salvage

2

Average Investment =

(Continued on the following page)

Thus, the return on average investment of I nvestment A is:

= = $24,000Average Investment$40,000 + $8,000

2

Average Estimated Net Income


E26.3


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Ex. 26.4 a.

b.

c.d.

Ex. 26.5

(Continued on the following page)

I nvestment A

$10,000 .061 = $610

$15,000 5.019 = $75,285

($10,000 3.352) + ($12,000 .497) = $33,520 + $5,964 = $39,484There are several ways to approach this problem. Shown below is the

of $20,000 received annually for 5 years plus the present value of

$10,000 received annually for the first 3 years:

Net present value (given as zero)

Thus, original cost of I nvestment A is:

Present value of annual net cash flows discounted at 12% for 10 years

($35,000 - $ ?) 5.650 (from Exhibit 26.4)

($16,000 - $6,000) 6.145 (from Exhibit 26.4)

Less: Investment cost

=2

Thus, the original investment cost of I nvestment Dis:

Original Cost + Salvage Value

I nvestment B

= $20,000

The missing information for each investment is solved for as follows:

Present value of annual net cash flows discounted at 10% for 10 years



Average Investment

Salvage Value = ($20,000 2) - $4,000 = $36,000

Average Investment

($20,000 3.352) + ($10,000 2.283) = $67,040 + $22,830 = $89,870

Alternatively, the student could determine the present value of $3

annually for 3 years ($68,490) and then add the present value of $20,0

the end of the fourth year ($11,440) and the present value of an

received at the end of the fifth year ($9,940).

2=

$ ? + $4,000

Average Investment = $3,000 15% = $20,000

I nvestment D

The average investment of I nvestment Dis:


$ ?= 15%

Average Investment

$3,000


E26.4,5


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$ 61,450

?

$ 0

$ 61,450

$ ?

141,250

$ 0

present value

he additional

,000 received

00 received at

other $20,000


E26.4,5


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Ex. 26.6 $300,000

$325,000 - $225,000

b.

$25,000

$300,000 2

c.


Annual Net Cash Flow=

Less: Amount to be invested

Net present value of proposal

Net present value of proposal, discounted at an annual rate of 12%:

Total present value of annual net cash flows

($325,000 - $225,000) 3.037

Average Investment= = 16.7%

Return on average investment:

Average Net Income

Given a net present value of zero, we can conclude that the discounted present value o

cash flows associated with I nvestment Bmust equal the investments original cost of $

Present value of annual net cash flows discounted at ?% for 10 years

($19,000 - $7,000) ?%


I nvestment C

Thus, the annual cash outflows associated with the investment can be computed as foll

($35,000 - Cash Outflows) 5.650 = $141,250

($35,000 5.650) - (5.650 Cash Outflows) = $141,250

Given a net present value of zero, we can conclude that the discounted present value o

cash flows associated with I nvestment C must equal the investments original cost of $

Thus, the discount rate associated with the investment that yields a net present value

be computed as follows:


($19,000 - $7,000) PV Factor = $88,320

$12,000 PV Factor = $88,320

$197,750 - (5.650 Cash Outflows) = $141,250

Cash Outflows = $56,500 5.650 = $10,000

$197,750 - $141,250 = (5.650 Cash Outflows)

$56,500 = (5.650 Cash Outflows)

a.Payback

Period=

PV Factor = $88,320 $12,000 = 7.36

In Exhibit 26-4, we find that the factor 7.36 is associated with a discount rate of 6%. T

discount rate yielding a net present value of zero for I nvestment Cis 6%.


E26.6


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$ ?

88,320

$ 0

$ 303,700

300,000

$ 3,700

the future

141,250.

ows:

the future

8,320.

f zero can

hus, the

= 3 years


E26.6


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Ex. 26.7 a.

$530,000

$200,000

b.

$ 517,800

24,100

$ 541,900

530,000

$ 11,900

c.

Ex. 26.8 a. $300,000b. 3 years

c. 16 2/3%

d. $911,100

e. $11,100

Ex. 26.9 a.

[$911,100 (part d) - $900,000 investment]

This is a very complex question with no single correct answer. If all division

managers commonly overstate cash flow projections in order to obtain funding

for their proposals, it certainly would be tempting for a new manager to do so

also. However, to blatantly lie about projections is an unethical practice, and

such behavior should be avoided. If you were to make your projections as

objective as possible, and support all of your assumptions with well-

documented evidence of their reliability, you might actually have more leverage

than a competing division manager who made inflated projections without

documented support.

Less: Original cost of investment

Net present value

There are several nonfinancial issues that Northwest Records should consider.

First, musical tastes often change very quickly. As such, an estimate that thegrunge sound will remain popular for four years is only a speculative guess.

Second, even if the grunge sound remains popular, there is no guarantee that

Seattle Sound will be able to attract the best talent. Finally, the most valuable

asset that Seattle Sound possesses is its management team. This team is

ultimately responsible for signing contracts and making deals with big-name

grunge bands. It is very important for Northwest Records to establish a legal

clause that forbids Seattle Sound employees from leaving and establishing their

own competing companies.

[$300,000 cash flow (part a) 3.037] (from Exhibit 26.4)

($975,000 receipts - $675,000 cash expenses)[$900,000 investment $300,000 cash flow (part a)]

[$75,000 income ($900,000 2)]

years discounted at a rate of 20% is $200,000 2.589

Present value of the investments $50,000 salvage value at

the end of year 4, discounted at a rate of 20% is

Total present value of all cash flows

Present value of net cash flows of $200,000 per year for 4

$50,000 .482 (from Exhibit 26.3)

(from Exhibit 26.4)

The payback period of the Seattle Sound investment is computed as follows:

= = 2.65 years

The net present value of the Seattle Sound investment is computed as follows:


Estimated Annual Net Cash


E26.7,8,9


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b.

Ex. 26.10

a. Net present value:

Calculate depreciation expense under each alternative:

New machine ($120,000 5 years) 24,000$

Old machine ($100,000 5 years) 20,000

Increase in depreciation of new machine 4,000$

Calculate the incremental increase in annual income taxes resultingfrom the purchase of the new machine:

Cost savings of new machine 34,000$

Less: Increase in depreciation (see above) 4,000

Increase in pretax income 30,000$

Income tax rate 40%

Increase in income taxes 12,000$

Calculate the incremental increase in annual cash flow resulting from

the purchase of the new machine:

Cost of savings of new machine 34,000$

Less: Increase in income taxes (see above) 12,000

Increase in annual cash flow 22,000$

Calculate the tax savings resulting from the loss on the sale of the

old machine:

Book value of old machine 100,000$

Proceeds from sale 20,000

Loss on sale of disposal 80,000$

Income tax rate 40%

Tax savings resulting from loss on disposal 32,000$

The net present value of the new machine can now be computed as follows:

Present value of incremental annual cash flows discounted at 12%

for five years is $22,000 3.605 (from Exhibit 26.4) 79,310$

Present value of tax savings from loss on disposal of the old machine

discounted at 12% for 1 year is $32,000 .893 (from Exhibit 26.3) 28,576

Present value of proceeds from sale of old equipment 20,000

Total present value 127,886$

Less: Cost of new machine 120,000

Net present value 7,886$

There are numerous controls that might be implemented to discourage the overstatement of

capital budgeting estimates. First, whenever possible, assumptions and projections should be

well documented with objective support. Second, managers who receive funding for their

proposals should be required to submit post-implementation reports on the actual success of

their projects. Managers should be evaluated, in part, based upon the extent to which a

division achieves budget projectionsincluding capital budgeting estimates.


E26.10


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Ex. 26.11 a. b.

$ 80,000 $ 20,000

70,000 70,000

$ 10,000 $ (50,000)

$ (4,000)

$ 20,000

$ 76,000

$ 40,000

Ex. 26.12

$ 80,000

32,000

$ 48,000

$ 14,000

$ 62,000

Ex. 26.13 a. NPV = ($300,000 6.71) - $2,000,000 = $13,000.

b.

c.

Net Inflow

Cash effects of depreciation

($35,000 .40)

Tax Savings at 40%

Net cash effect of sale:

($80,000 - $4,000)

The NPV is positive indicating they should purchase the MRI.

The hospital may have some commitment to the community andcommunity considerations are always important in hospital

investments. In addition, the number of MRIs already in operation in

the surrounding area, the financing, whether there is newer technology

on the horizon, whether it has the skilled labor to operate the MRI, etc.

are nonfinancial considerations.

Cash flow from operations:

($150,000 - $70,000)Tax outflow at 40%

Total after tax effect on cash

(excluding depreciation)

c.

b. Perhaps the most important nonfinancial consideration for EnterTech

to consider is the future demand for portable CD players. If demand

for the product is less than five years, the investment in the new

machine is far less attractive. Management should also explore the

possibility of finding an alternative use for the machine once portable

CD players are no longer manufactured. Finally, it should evaluate any

alternative investment opportunities the company may have.

Because the decision of whether or not to invest in the new machine is

highly dependent on the cost savings estimate, EnterTech may want to

obtain a second estimate from a neutral third party. Estimates could

be obtained from sources such as consulting firms, engineers from an

outside division (that would not have a stake in the investment), or the

finance department.

($20,000 + $20,000)

Cash proceeds of sale

Book value:[$175,000 - 3 (35,000)]

Gain (Loss) on Sale

Taxes Paid at 40%


E26.11,12,13


22/60

Ex. 26.14

5% rate 5% NPV 8% rate 8% NPV

Year 1 0.952 $142,800 0.926 $138,900

Year 2 0.907 199,540 0.857 188,540

Year 3 0.864 216,000 0.794 198,500

Year 4 0.823 144,025 0.735 128,625

Total NPV $702,365 $654,565

Ex. 26.15 a.

b.

c.

$ 91 million

29 million

$ 120 million

$ 120 million

42 million

$ 78 million

d.

$175,000

Home Depot closed 20 of its Expo stores and two Home Depot Supply stores in

2005.

Amount

$150,000

$220,000

$250,000

Home Depot charged a total of $91 million to SG&A related to the disposition of

the Expo stores. Of this total, $78 million was for asset impairment charges and

$13 million was for lease obligations. In addition, Home Depot incurred $29

million of Cost of Sales expense related to inventory markdowns in the Expo

Stores.

The tax-related impact of the charges to SG&A and inventory markdowns on

2005 annual net income are computed as follows:

Home Depot mentions that customers affected by the closings of the 20 stores

are being served by other existing Home Depot and Expo stores. Other

nonfinancial factors include the impact on suppliers, employees and

communities that the stores supported. Corporate reputation can be harmed by

large-scale or capricious store closings.

Decrease in annual pretax operating income from

impairment

Less: decrease in income taxes (at 35%)

Net decrease in annual net income from impairment

Increase in SG&A

Increase in Cost of Sales .

Total increase in expenses


E26.14,15


23/60

SOLUTIONS TO PROBLEMS SET A

30 Minutes, Strong PROBLEM 26.1ATOYING WITH NATURE

a.

Estimated sales (80,000 units @ $6) 480,000$

Less estimated incremental costs:

Variable manufacturing costs (80,000 units @ $2.50) 200,000$

Fixed manufacturing costs (except depreciation) 45,000

Depreciation expense [($350,000 - $20,000) 3] 110,000

Selling and general expenses 55,000 410,000

Income before income taxes 70,000$

Income taxes expense ($70,000 40%) 28,000

Estimated increase in annual net income 42,000$

b. Computation of annual net cash flow:

Cash receipts 480,000$

Less cash outlays:

Variable manufacturing costs 200,000$

Fixed costs (other than depreciation) 45,000

Selling and general expenses 55,000

Income taxes expense 28,000 328,000

Annual net cash flow from sale of new product 152,000$

c. (1)$350,000

$152,000

(2)

(3) Net present value of project, discounted at 15%:

Total present value of annual net cash flows ($152,000 2.283) 347,016$Present value of salvage, due in three years ($20,000 .658) 13,160


Less: Amount to be invested 350,000

Net present value of this project 10,176$

2.3 years

= 22.7%

Amount Invested

Annual Net Cash Flow= =

TOYING WITH NATURE

Schedule of Estimated Net Income

(350,000 + $20,000) 2

42,000


Annual Net Income

Average Investment=

Payback period:


P26.1A


24/60

PROBLEM 26.2AMICRO TECHNOLOGY

a.

(1)

(2)

(3) Net present value, discounted at 12%:

Total present value of eight annual net cash flows ($75,000 4.968) 372,600$


Net present value of proposal 12,600$

(1)

(2)


Total present value of seven annual net cash flows ($76,000 4.564) 346,864$

Present value of salvage value due in seven years ($14,000 .452) 6,328




b.

25 Minutes, Medium

Proposal 2

$30,000 ($360,000 2)$30,000 $180,000 = 16.7%

Proposal 1

Payback period:

$360,000 $75,000 = 4.8 yearsReturn on average investment:

$28,000 $182,000 = 15.4%

From the information above, Proposal 1 appears to be the better investment. Although

Proposal 2has a slightly shorter payback period, Proposal 1is more profitable, as indicated

by the higher return on average investment and greater net present value.

$350,000 $76,000 = 4.6 years

Payback period:


$28,000 [($350,000 + $14,000) 2]


P26.2A


25/60

25 Minutes, Medium PROBLEM 26.3A

BANNER EQUIPMENT CO.

a.

(1)

(2)


Total present value of five annual net cash flows ($60,000 3.605) 216,300$

Present value of salvage value due in five years ($10,000 .567) 5,670


Less: Amount to be invested 220,000Net present value of proposal 1,970$

(1)

(2)


Total present value of six annual net cash flows ($60,000 4.111) 246,660$



b.

Proposal A

Payback period:

$220,000 $60,000 = 3.7 yearsReturn on average investment:


$20,000 ($240,000 2)

$20,000 $120,000 = 16.7%

From the information above, Proposal Bappears to be the better investment. Although

Proposal A has a shorter payback period, Proposal Bis more profitable, as indicated by the

higher return on average investment and greater net present value.

$240,000 $60,000 = 4 years

$18,000 [($220,000 + $10,000) 2]

$18,000 $115,000 = 15.7%

Proposal B

Payback period:


P26.3A


26/60

25 Minutes, Medium PROBLEM 26.4MARENGO

a.

(1)

(2)


Total present value of 10 annual net cash flows ($80,000 5.019) 401,520$

Present value of salvage value due in 10 years ($20,000 .247) 4,940Total present value 406,460$



(1)

(2)


Total present value of 10 annual net cash flows ($95,000 5.019) 476,805$Present value of salvage value due in 10 years ($50,000 .247) 12,350


Less: Amount to be invested 500,000Net present value of proposal (10,845)$

b. Based upon the above analysis, Proposal A is the only acceptable investment of the two

proposals under consideration. Both proposals have acceptable payback periods (less than

the useful life of fixtures) and acceptable rates of return on investment (higher than

managements required 15%). However, the negative net present value of Proposal B

dictates rejection of this proposal as a possible investment. The positive net present value ofProposal A indicates that this option is the more profitable alternative.

Note to instructor:The net present value calculation is the best of the three capital budgeting

models because it is based on cash flows and because it considers profitability and the time

value of money. Each of the other two simpler models ignores two of these factors.

Proposal B

Payback period:

$500,000 $95,000 = 5.3 years


($95,000 - $45,000) [($500,000 + $50,000) 2]

$50,000 $275,000 = 18.2%

($80,000 - $38,000) [($400,000 + $20,000) 2]

$42,000 $210,000 = 20%

Proposal A

Payback period:

$400,000 $80,000 = 5.0 years



P26.4A


27/60

25 Minutes, Medium PROBLEM 26.5AV.S. YOGURT

a.

(1)

(2)


Total present value of seven annual net cash flows ($750,000 4.160) 3,120,000$

Less: Amount to be invested 3,150,000

Net present value of proposal (30,000)$

(1)

(2)


Total present value of seven annual net cash flows ($570,000 4.160) 2,371,200$

Present value of salvage due in seven years ($400,000 .376) 150,400

Total present value 2,521,600$



b.

($750,000 - $450,000) ($3,150,000 2)

$300,000 $1,575,000 = 19.0%


($570,000 - $300,000) [($2,500,000 + $400,000) 2]

Proposal A

Payback period:

$3,150,000 $750,000 = 4.2 yearsReturn on average investment:

Note to instructor: The net present value calculation is the best of the three capital budgeting

models because it is based on cash flows and because it considers profitability and the time value

of money. Each of the other two simpler models ignores two of these factors.

Proposal B

Payback period:

$2,500,000 $570,000 = 4.4 years

$270,000 $1,450,000 = 18.6%

Based on the above analysis, Proposal B is the only acceptable investment of the two

proposals under consideration. Although Proposal A has a slightly shorter payback period

and a higher return on average investment, the negative net present value of this proposal

dictates rejection of Proposal A. The positive net present value of Proposal B, accompanied

by an acceptable payback period and return on average investment, indicates that Proposal

B is the more profitable investment strategy.


P26.5A


28/60

30 Minutes, Strong PROBLEM 26.6AROTHMORE APPLIANCE COMPANY

a.

Estimated sales (10,000 units @ $35) 350,000$Less estimated incremental costs:

Variable manufacturing costs (10,000 units @ $15) 150,000$


Depreciation expense ($240,000 4) 60,000




Net income 30,000$



Less cash outlays:Variable manufacturing costs 150,000$




Annual net cash flow 90,000$

c. (1)

$240,000$90,000

(2)

$30,000

$240,000 2


Total present value of annual cash flows ($90,000 2.855) 256,950$

Less: Amount to be invested 240,000Net present value of project 16,950$

Annual Net Income

Average Investment

=

=

ROTHMORE APPLIANCE COMPANY


= 2.7 years

= 25%

Payback period:

Amount InvestedAnnual Net Cash Flow



P26.6A


29/60

40 Minutes, Strong PROBLD

a.

$1,250,000

$243,750

The supporting calculations for the above payback figure are:

Incremental annual revenue of investment

Less: Incremental annual expenses of investment

Incremental annual income of investment

Add: Depreciation expense

Incremental annual cash flow of investment

b.

$100,000

$675,000

$1,250,000 + $100,000

2

=

=


*Depreciation expense: [$1,250,000 - $100,000 ] 8 years = $143,750


Average Investment

Average Investment


2


Payback period:


Estimated Annual Net Cash Flow

= = 5.13 years

Thus, the MRIs return on average investment is:

= $675,000


P26.7A


30/60

M 26.7AOCTORS

800,000$

700,000

100,000$

143,750*

243,750$


P26.7A


31/60

PROBLEM 26.7ADOCTORS (concluded)

c. Net present value:The discounted present value of the incremental annual cash flow of

the investment (see part a) discounted at 12% for 8 years is

$243,750 4.968 (from Exhibit 26.4) 1,210,950$

The discounted present value of the investments salvage value

discounted at 12% for 8 years is $100,000 .404 (from Exhibit 26.3) 40,400

Discounted present value of all cash flows 1,251,350$

Less: Cost of investment 1,250,000


As shown above, the net present value of the MRI investment is only

$1,350. Thus, we may conclude that the investments actual rate of

return is only slightly greater than 12%.

d. Some of the nonfinancial factors that the doctors should consider include (1) the pace at

which MRI technology is changing, (2) changes in legislation pertaining to government

funding of medical benefits, (3) legal considerations related to the formation and operation

of a corporation, (4) their ethical responsibility to provide quality health care to rural areas,

(5) alternative investment opportunities, and (6) their eligibility to acquire grants and other

sources of external financing for this activity.


P26.7A (p.2)


32/60

50 Minutes, Strong PROBLEM 26.8AJEFFERSON MOUNTAIN

a.

$125,000$31,250

The supporting calculations are:

Incremental annual revenue of investment 40,000$

Less: Incremental annual expenses of investment 15,000

Incremental annual income of investment 25,000$

Add: Depreciation expense 6,250*

Incremental annual cash flow of investment 31,250$

$180,000

$40,000

The supporting calculations for the payback period figure are:






*Depreciation expense: $180,000 36 years = $5,000

Chair L ift



Estimated Annual Net Cash Flow= = 4.5 years

Payback period:

Snow-Making Equipment

Amount to Be InvestedEstimated Annual Net Cash Flow

= 4 years=


P26.8A


33/60

PROBLEM 26.8AJEFFERSON MOUNTAIN (continued)

b.

$125,000 + $0

2

$25,000

$62,500

$35,000

$90,000

c. Net present value:


The discounted present value of the incremental annual cash flow of


$31,250 4.870 (from Exhibit 26.4) 152,188$

Less: Cost of investment 125,000


Chair LiftThe discounted present value of the incremental annual cash flow of


$40,000 4.993 (from Exhibit 26.4) 199,720$






2

Average

Investment=

Average

Investment

= 40%Average Estimated Net Income

=Average Investment

Thus, the return on average investment is:


2

$180,000 + $0

2= $90,000

= = $62,500


Average Estimated Net Income= = 38.89%

Average Investment

Chair L ift

Average

Investment

Average

Investment

=

=


P26.8A (p.2)


34/60

PROBLEM 26.8AJEFFERSON MOUNTAIN (concluded)

d.

e.

The management of Jefferson Mountain must decide which investment opportunity will

best serve its customers. Thus, it must try to determine if adequate snow coverage with long

lift lines is better than short lift lines with limited snow coverage. A marketing study could

be conducted to gain a better understanding of customer expectations. In addition,management should also consider the condition of the resorts existing chair lifts, recent

weather patterns, and alternative investment opportunities.

It is likely that management will elect to invest in snow-making equipment. This investment

has the shortest payback period, a greater return on average investment, and a higher net

present value. Skiers are more likely to tolerate long lift lines if snow conditions are good

than short lift lines with poor snow conditions. Once the equipment has been installed,

management can begin to make plans regarding the future investment in a high-speed chair

lift.


P26.8A (p.3)


35/60

45 Minutes, Strong PROBLEM 26.9ASONIC, INC.

a.

$300,000

$100,000







$240,000

$70,000

The supporting calculations for the payback figure are:







Payback period:

Computer Chip Equipment


Estimated Annual Net Cash Flow= 3 years=

Software Bank I nstallation





P26.9A


36/60

PROBLEM 26.9ASONIC, INC. (continued)

b.

$300,000 + $0

2

$50,000

$150,000

$240,000 + $0

2

$30,000

$120,000





$100,000 3.784 (from Exhibit 26.4) 378,400$



Software Bank Instal lat ion



$70,000 3.784 (from Exhibit 26.4) 264,880$




Average Investment= 25%


2

= $120,000


Average

Investment

Average

Investment

=

=

= = $150,000Average

Investment

Software Bank I nstallation


Average Investment


= 33.33%




2

Average

Investment=


P26.9A (p.2)


37/60

PROBLEM 26.9ASONIC, INC. (concluded)

d.

e.

f.

There are several nonfinancial considerations worth mentioning. First, the company must

try to determine which medium the customers are most likely to use. Second, it must try to

determine future industry trends regarding software distribution. Third, it must evaluate

which medium provides the most protection against piracy and theft. Fourth, it mustconsider the risk of having their software bank installation infected with a computer virus.

Finally, the company should consider whether other investment opportunities are available.

If Sonic invests in the software bank, there will no longer be a need for employees to load

programs onto disks of any type, process orders, or package and ship program disks. If the

employees and managers who currently perform these tasks believe they may be terminated

if the investment is made, they will likely be biased against it and underestimate its benefits.

It is likely that management will elect to invest in the computer chip. In addition to being an

accepted method of software distribution, the investment has the shortest payback period, a

greater return on average investment, and a higher net present value.


P26.9A (p.3)


38/60

SOLUTIONS TO PROBLEMS SET B

30 Minutes, Strong PROBLEM 26.1BMONSTER TOYS

a.


Variable manufacturing costs (100,000 units @ $3.00) 300,000$Fixed manufacturing costs (except depreciation) 60,000Depreciation expense [($400,000 - $10,000) 3] 130,000Selling and general expenses 40,000 530,000

Income before income taxes 270,000$Income taxes expense ($270,000 30%) 81,000Estimated increase in annual net income 189,000$

b. Computation of annual net cash flow:Cash receipts 800,000$Less cash outlays:

Variable manufacturing costs 300,000$Fixed costs (other than depreciation) 60,000Selling and general expenses 40,000Income taxes expense 81,000 481,000

Annual net cash flow from sale of new product 319,000$

c. (1)$400,000

$319,000

(2)


Total present value of annual net cash flows ($319,000 2.402) 766,238$

Present value of salvage, due in three years ($10,000 .712) 7,120



Net present value of this project 373,358$

= 92.2%


Annual Net Income

Average Investment=

189,000

($400,000 + $10,000) 2

Annual Net Cash Flow= = 1.25 years

MONSTER TOYSSchedule of Estimated Net Income

Payback period:Amount Invested


P26.1B


39/60

PROBLEM 26.2BMACRO TECHNOLOGY

a.

(1)

(2)


Total present value of ten annual net cash flows ($80,000 5.019) 401,520$



(1)

(2)


Total present value of eight annual net cash flows ($82,000 4.487) 367,934$

Present value of salvage value due in eight years ($20,000 .327) 6,540




b.

$37,000 $200,000 = 18.5%

From the information above, Proposal 1 appears to be the better investment. Although

Proposal 2has a slightly shorter payback period and a higher return on average investment,

it also has a negative net present value and consequently it is not getting a 15% return.

$380,000 $82,000 = 4.6 years

Payback period:


$37,000 [($380,000 + $20,000) 2]

25 Minutes, Medium

Proposal 2

$40,000 ($400,000 2)

$40,000 $200,000 = 20%

Proposal 1

Payback period:

$400,000 $80,000 = 5 yearsReturn on average investment:


P26.2B


40/60

25 Minutes, Medium PROBLEM 26.3B

FLAGG EQUIPMENT CO.a.

(1)

(2)


Total present value of six annual net cash flows ($82,000 3.784) 310,288$

Present value of salvage value due in six years ($20,000 .432) 8,640




(1)

(2)


Total present value of seven annual net cash flows ($65,000 4.160) 270,400$



b. From the information above, Proposal A appears to be the better investment. Proposal Ahas a shorter payback period and is more profitable, as indicated by the higher return on

average investment and greater net present value.

Proposal A

Payback period:

$260,000 $82,000 = 3.2 years


$280,000 $65,000 = 4.3 years

$42,000 [($260,000 + $20,000) 2]$42,000 $140,000 = 30%

Proposal B

Payback period:


$25,000 ($280,000 2)$25,000 $140,000 = 17.9%


P26.3B


41/60

25 Minutes, Medium PROBLEM 26.4BTANGO

a.

(1)

(2)

(3) Net present value, discounted at 12%:Total present value of 10 annual net cash flows ($75,000 5.650) 423,750$Present value of salvage value due in 10 years ($10,000 .322) 3,220Total present value 426,970$Less: Amount to be invested 250,000Net present value of proposal 176,970$

(1)

(2)


Total present value of 10 annual net cash flows ($50,000 5.650) 282,500$

Present value of salvage value due in 10 years ($40,000 .322) 12,880




b.

($75,000 - $24,000) [($250,000 + $10,000) 2]$51,000 $130,000 = 39.2%

Proposal A

Payback period:

$250,000 $75,000 = 3.3 years



models because it is based on cash flows and because it considers profitability and the time

value of money. Each of the other two simpler models ignores two of these factors.

Based upon the above analysis, Proposal A is the only acceptable investment of the two

proposals under consideration. Both proposals have acceptable payback periods (less than

the useful life of fixtures). However, the negative net present value and unacceptable rate

of return on investment (lower than managements required 12%) of Proposal Bdictates

rejection of this proposal as a possible investment. The positive net present value and

acceptable rate of return on investment (higher than managements required 12%) of

Proposal A indicates that this option is the more profitable alternative.

Proposal B

Payback period:

$300,000 $50,000 = 6.0 years


($50,000 - $36,000) [($300,000 + $40,000) 2]

$14,000 $170,000 = 8.2%


P26.4B


42/60

25 Minutes, Medium PROBLEM 26.5BI.C. CREAM

a.

(1)

(2)


Total present value of eight annual net cash flows ($800,000 4.968) 3,974,400$



(1)

(2)

(3) Net present value, discounted at 12%:Total present value of eight annual net cash flows ($700,000 4.968) 3,477,600$

Present value of salvage due in eight years ($200,000 .404) 80,800

Total present value 3,558,400$



b.

Proposal A

Payback period:

$4,000,000 $800,000 = 5 years


($800,000 - $500,000) ($4,000,000 2)

$300,000 $2,000,000 = 15%


models because it is based on cash flows and because it considers profitability and the time value

of money. Each of the other two simpler models ignores two of these factors.


($700,000 - $350,000) [($3,000,000 + $200,000) 2]

$350,000 $1,600,000 = 21.9%

Based on the above analysis, Proposal Bis the only acceptable investment of the two

proposals under consideration. Although Proposal A has an acceptable payback period and

return on average investment, the negative net present value of this proposal dictates

rejection of Proposal A . The positive net present value of Proposal B, accompanied by ashorter payback period and a higher return on average investment, indicates that Proposal B

is the more profitable investment strategy.

Proposal B

Payback period:

$3,000,000 $700,000 = 4.3 years


P26.5B


43/60

30 Minutes, Strong PROBLEM 26.6BCAFIELD APPLIANCE COMPANY

a.


Variable manufacturing costs (15,000 units @ $18) 270,000$


Depreciation expense ($300,000 5) 60,000




Net income 94,500$



Less cash outlays:

Variable manufacturing costs 270,000$




Annual net cash flow 154,500$

c. (1)

$300,000

$154,500

(2)

$94,500

$300,000 2


Total present value of annual cash flows ($154,500 3.605) 556,973$Less: Amount to be invested 300,000

Net present value of project 256,973$

Average Investment

= 1.9 years

= 63%

=

=

Amount Invested

Annual Net Cash Flow


CAFIELD APPLIANCE COMPANY


Payback period:

Annual Net Income


P26.6B


44/60

40 Minutes, Strong PROBLD

a.

$1,500,000

$244,444







b.

$100,000

$850,000

*Depreciation expense: [$1,500,000 - $200,000 ] 9 years = $144,444



2=

=

Average Investment

Average Investment

Payback period:


Estimated Annual Net Cash Flow

= = 6.14 years

$1,500,000 + $200,000

2


Thus, the MRIs return on average investment is:

= $850,000



P26.7B


45/60

M 26.7BOCTORS

900,000$

800,000

100,000$

144,444*

244,444$


P26.7B


46/60

PROBLEM 26.7BDOCTORS (concluded)

c. Net present value:The discounted present value of the incremental annual cash flow of


$244,444 4.772 (from Exhibit 26.4) 1,166,487$

The discounted present value of the investments salvage value

discounted at 15% for 9 years is $200,000 .284 (from Exhibit 26.3) 56,800

Discounted present value of all cash flows 1,223,287$

Less: Cost of investment 1,500,000

Net present value (276,713)$

As shown above, the net present value of the MRI investment is negative. Thus,

we may conclude that the investments actual rate of return is less than 15%.

d. Some of the nonfinancial factors that the doctors should consider include (1) the pace at

which MRI technology is changing, (2) changes in legislation pertaining to government

funding of medical benefits, (3) legal considerations related to the formation and operation

of a corporation, (4) their ethical responsibility to provide quality health care to rural areas,

(5) alternative investment opportunities, (6) their eligibility to acquire grants and other

sources of external financing for this activity, (7) the possibility of increasing fees, and (8)

including more doctors in the corporation.


P26.7B (p.2)


47/60

50 Minutes, Strong PROBLEM 26.8BMADISON MOUNTAIN

a.

$150,000$45,000







$200,000

$48,000

The supporting calculations for the payback period figure are:







Payback period:



= 3 1/3 years=

Chair L ift





P26.8B


48/60

PROBLEM 26.8BMADISON MOUNTAIN (continued)

b.

$150,000 + $0

2

$30,000

$75,000

$200,000 + $0

2

$38,000

$100,000




the investment (see part a) discounted at 20% for 10 years is$45,000 4.192 (from Exhibit 26.4) 188,640$

Less: Cost of investment 150,000Net present value 38,640$

Chair Lift

The discounted present value of the incremental annual cash flowof the investment (see part a) discounted at 20% for 20 years is$48,000 4.870 (from Exhibit 26.4) 233,760$




Average Investment= 38%


2

= $100,000


Average

Investment

Average

Investment

=

=

= = $75,000Average

Investment

Chair L ift


Average Investment


= 40%




2

Average

Investment=


P26.8B (p.2)


49/60

PROBLEM 26.8BMADISON MOUNTAIN (concluded)

d.

e.

The management of Madison Mountain must decide which investment opportunity will best

serve its customers. Thus, it must try to determine if adequate snow coverage with long lift

lines is better than short lift lines with limited snow coverage. A marketing study could be

conducted to gain a better understanding of customer expectations. In addition, managementshould also consider the condition of the resorts existing chair lifts, recent weather patterns,

and alternative investment opportunities.

It is likely that management will elect to invest in snow-making equipment. This investment

has the shortest payback period, a greater return on average investment, and a higher net

present value. Skiers are more likely to tolerate long lift lines if snow conditions are good

than short lift lines with poor snow conditions. Once the equipment has been installed, the

management can begin to make plans regarding the future investment in a high-speed chair

lift.


P26.8B (p.3)


50/60

45 Minutes, Strong PROBLEM 26.9BBOOM, INC.

a.

$500,000

$240,000







$350,000

$190,000

The supporting calculations for the payback figure are:







Program Bank Installation




Payback period:

Memory Stick


Estimated Annual Net Cash Flow= 2.08 years=


P26.9B


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PROBLEM 26.9BBOOM, INC. (continued)

b.

$500,000 + $0

2

$140,000

$250,000

$350,000 + $0

2

$120,000

$175,000


Memory St ick



$240,000 3.605 (from Exhibit 26.4) 865,200$



Program Bank Instal lat ionThe discounted present value of the incremental annual cash flow of


$190,000 3.605 (from Exhibit 26.4) 684,950$



= 56%


Memory Stick


2

Average

Investment=

= = $175,000

= = $250,000Average

Investment

Program Bank Installation


Average Investment




Average Investment= 68.6%


2

Average

Investment

Average

Investment

=


P26.9B (p.2)


52/60

PROBLEM 26.9BBOOM, INC. (concluded)

d.

e.

f.

There are several nonfinancial considerations worth mentioning. First, the company must

try to determine which medium the customers are most likely to use. Second, it must try to

determine future industry trends regarding software distribution. Third, it must evaluatewhich medium provides the most protection against piracy and theft. Fourth, it must

consider the risk of having their program bank installation infected with a computer virus.

Finally, the company should consider whether other investment opportunities are available.

If Boom invests in the program bank, there will no longer be a need for employees to load

programs onto disks of any type, process orders, or package and ship program disks. If the

employees and managers who currently perform these tasks believe they may be terminated

if the investment is made, they will likely be biased against it and underestimate its benefits.

Both are excellent investments with low payback periods, high return on investments and

positive net present values. The ultimate decision should be a marketing one.


P26.9B (p.3)


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SOLUTIONS TO CRITICAL THINKI

a.

b.

25 Minutes, Strong

Present value of estimated incremental annual cash flows for 10 years:

$114,000 5.019 (Exhibit 26.4)

Net present value of proposal, discounted at an annual rate of 15%:

THE CASE OF THE COS

Amount to be invested (to be paid immediately) .

Net present value of proposal

The cost of the laser printer is $1,300,000, not $2,500,000 as Adams suggests.

including the $1,200,000 after-tax loss on the sale of the existing equipment as

of the laser printer. This $1,200,000 is part of the cost of the old equipment, n

printer. The $1,200,000 is a sunk costthat is, it has alr eady been incur reda

regardless of whether the existing equipment is sold or continued in use. The

printer consists only of the $1,300,000 price which must be paid to purchase i

Present value of proceeds from sale of existing equipment

Present value of tax savings from loss on disposal of existing equipment,

realized in 1 year: $800,000 .870 (Exhibit 26.4)

(received immediately)

Total present value


Case 26.1


54/60

NG CASES

$ 572,166

200,000

696,000

$ 1,468,166

1,300,000

$ 168,166

CASE 26.1LY LASER

dams is

part of the cost

t of the laser

d exists

ost of the laser

.


Case 26.1


55/60

60 Minutes, Strong CGRIZZLY COMMUNITY H

a.

$4,500,000$525,000







$300,000

$2,250,000

Net Present Value


the investment (see above) discounted at 12% for 20 years is

$525,000 7.469 (from Exhibit 26.4)

Less: Cost of investment

Net present value

The negative net present value computed above indicates that

expected return of the center is less than the 12% return required

by the hospital.

2

$4,500,000 + $0

2= $2,250,000

=

=


*Depreciation expense: 4,500,000 20 years = $225,000


Average Investment

Average Investment



Relevant financial measures introduced in the chapter include:

Payback period


= = 8.57 years



Case 26.2


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ASE 26.2 OSPITAL

1,150,000$

850,000

300,000$

225,000*

525,000$

3,921,225$

4,500,000

(578,775)$


Case 26.2


57/60

CASE 26.2

b.

c.

There are many nonfinancial issues related to this decision. Questions that should be

addressed include (1) Would those patients who now travel 300 miles for treatment utilize

the Grizzly facility? (2) Is the staff of Grizzly trained to deliver quality dialysis care to

kidney patients? (3) Is a helicopter that would provide emergency care to rural areas abetter use of hospital funds? (4) Does a hospital have an ethical responsibility to deliver

comprehensive services even if some are unprofitable? (5) Is a hospital a business? (6)

What will be the impact on the hospital if one or more physicians move out of the area if a

dialysis center is not built? (7) What state, federal, or private funding is available for this

type of facility? (8) What alternative investment opportunities does the hospital have?

The estimates of the revenues and costs associated with the dialysis center were provided

by the physicians, who are strongly in favor of building the center. Due to their position on

the issue, these estimates may overstate the revenues and understate the costs of the center.

To make a well-informed decision, neutral estimates should be obtained from an outside

consulting firm or the hospitals finance division.

GRIZZLY COMMUNITY HOSPITAL (concluded)


Case 26.2 (p.2)


58/60

20 Minutes, Medium CASE 26.3

INTERNATIONAL INVESTMENTS IN OUTSCOURCINGBUSINESS WEEK

a.

b.

Lower cost does not always mean gains in efficiency implies that the cash flow savings

obtained from lower cost inputs overseas (labor for example) may be offset by higher costsand related cash flows due to reduced productivity. Often, lower labor costs go hand in

hand with less skilled labor. A lower skilled labor force will result in lower productivity

and efficiency.

Although companies have been known to undertake transfer of knowledge between

current and future employees, there are significant ethical concerns about asking currentemployees to train their offshore replacements. There is the potential for the employees to

be less than forthcoming about the knowledge required to successfully complete their job.

Thus, transfer of information may be incomplete or fraudulent. That is an ethical problem

on the part of the employees. The company bears some ethical responsibility in asking the

employees to share knowledge they may have gained over many years of work and

training, without additional compensation.

Choosing to run your own offshore operation versus outsourcing the management of that

operation can have significant cash flow implications. It is likely to be more costly to

manage your own offshore operation. However, gains in efficiency, productivity and

quality can offset those initial costs.

Current employees can hinder progress in completing an international investment if they

believe their jobs are ultimately in jeopardy. Creating a mechanism for fullcommunication and transparency is key to getting employees on board. In addition, if jobs

are being transferred overseas, then mechanisms for retraining and retaining current

employees will help make sure they are onboard. Of course these initiatives have

Finally, treating your partners as equals will result in tapping into your partners

knowledge which will far exceed your domestic-based understanding of the international

setting. That knowledge could have significant cash flow implications if it saves missteps in

the investment process from occurring.


Case 26.3


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CASE 26.4

INTERNET

a.

b.

c.

There are several capital investment decisions highlighted in the history section, including

the construction of a large mail order plant in Chicago in 1906, which was then the largestbusiness building in the world, and the subsequent construction of the Sears Tower in

1973. The establishment of the Allstate Insurance Company, Dean Witter Investments, the

acquisition of K-Mart, and the Discover Card, were also capital investment decisions

focused on expanding the scope of Sears operations.

In its decisions to invest in businesses not involved in retail sales (such as Allstate

Insurance), Sears would have had to consider whether these businesses would fit with its

current operations and whether they could be managed effectively. Customer preferences

would have also been analyzed to determine if they would be willing to buy

chapter 26- capital budgeting

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