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CHAPTER 14CAPITAL INVESTMENT DECISIONS

DISCUSSION QUESTIONS

1. Independent projects are such that theacceptance of one does not preclude theacceptance of another. With mutuallyexclusiveprojects, acceptance of one precludes theacceptance of others.

2. The timing and quantity of cash flowsdetermine the present value of a project.The present value is critical for assessingwhether a project is acceptable or not.

3. By ignoring the time value of money, good

projects can be rejected and bad projectsaccepted.

4. The payback period is the time required torecover the initial investment. Payback =$80,000/$30,000 = 2.67 years.

5. (a) A measure of risk. Roughly, projects withshorter paybacks are less risky. (b)Obsolescence. If the risk of obsolescence ishigh, firms will want to recover funds quickly.(c) Self-interest. Managers want quickpaybacks so that short-run performancemeasures are affected positively, enhancing

chances for bonuses and promotion.6. The accounting rate of return is the average

income divided by original or averageinvestment. ARR = $100,000/$300,000 =33.33%.

7. Agree. Essentially, net present value is ameasure of the return in excess of theinvestment and its cost of capital.

8. NPV measures the increase in firm valuefrom a project.

9. The cost of capital is the cost of investment

funds and is usually viewed as the weightedaverage of the costs of funds from all

sources. It should serve as the discount ratefor calculating net present value or thebenchmark for IRR analysis.

10. For NPV, the required rate of return is thediscount rate. For IRR, the required rate ofreturn is the benchmark against which theIRR is compared to determine whether aninvestment is acceptable or not.

11. If NPV > 0, then the investment isacceptable. If NPV < 0, then the investmentshould be rejected.

12. Disagree. Only if the funds received eachperiod from the investment are reinvested toearn the IRR will the IRR be the actual rateof return.

13. Postaudits help managers determine ifresources are being used wisely. Additionalresources or corrective action may beneeded. Postaudits serve to encouragemanagers to make good capital investmentdecisions. They also provide feedback thatmay help improve future decisions, The

claims and benefits of advanced technologyshould especially be examined by apostaudit because of the uncertaintysurrounding new technology.

14. NPV signals which investment maximizesfirm value; IRR may provide misleadingsignals. IRR may be popular because itprovides the correct signal most of the timeand managers are accustomed to workingwith rates of return.

15. Often, investments must be made in assetsthat do not directly produce revenues. In this

case, choosing the asset with the least cost(as measured by NPV) makes sense.

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MULTIPLE-CHOICE EXERCISES

141 a

142 e

143 c

144 a

145 d

146 e

147 c

148 b

149 d

1410 e

1411 b

1412 c

1413 a

1414 e

1415 c

1416 a

1417 e

1418 b

1419 e

1420 c

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CORNERSTONE EXERCISES

Cornerstone Exercise 1421

a. Payback period = $600,000

$2,400,000

= 4.00 years

b. Payback period:

$ 300,000 1.0 year300,000 1.0 year800,000 1.0 year800,000 1.0 year200,000 1.0 year

$2,400,000 5.0 years


Average net income =($200,000 +$600,000 + $1,000,000 + 1,200,000 + 1,600,000 + 2,200,000 + $1,600,000)

7

= $1,200,000

Accounting rate of return =Investment

incomenetAverage

= 0$10,000,00

$1,200,000

= 0.12


1. Year Item Cash Flow

0 Equipment $(480,000)Working capital (60,000)

Total $(540,000)

14 Revenues $ 450,000Operating expenses (270,000)

Total $ 180,000

5 Revenues $ 450,000Operating expenses (270,000)Salvage 60,000Recovery of working capital 60,000

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Total $ 300,000

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Cornerstone Exercise 1423 (Concluded)

2. Calculation of NPV:

Year Cash Flowa Discount Factorb Present Value

0 $(540,000) 1.00000 $(540,000)1 180,000 0.92593 166,6672 180,000 0.85734 154,3213 180,000 0.79383 142,8894 180,000 0.73503 132,3055 300,000 0.68058 204,174

Net present value $ 260,356aFrom Requirement 1.bFrom Exhibit 14B-1.

3. Calculation of NPV:

Year Cash Flowa Discount Factorb Present Value

0 $(540,000) 1.00000 $(540,000)14 180,000 3.31213 596,1835 300,000 0.68058 204,174

Net present value $ 260,357aFrom Requirement 1.bFrom Exhibit 14B-2.


df= I/CF=800,000

$4,607,200= 5.75900

From Exhibit 14B-2, nine years and a discount factor of 5.75900 yieldsan IRR = 10%.

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1. CAM X Model:

Year Cash Flow Discount Factor Present Value

0 $(1,200,000) 1.00000 $(1,200,000)110 300,000 6.14457 1,843,371

$ 643,371

CAM Y Model:


0 $(1,400,000) 1.00000 $(1,400,000)110 350,000 6.14457 2,150,600NPV $ 750,600

CAM Y is the better choice (it has the higher NPV)

2. df(CAM X) =CF

I=

1,200,000

300,000= 4.00000

df(CAM Y) =CF

I=

$1,400,000

350,000= 4.00000

A discount factor of 4.00000 for 10 years implies that IRR is between 25% and30%.

The IRR is equal for both models and so one is not preferred over the other.

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EXERCISES

Exercise 1426

1. Payback period = $96,000

$320,000

= 3.33 years

2. Payback period:

$175,000 1.0 year245,000 1.0 year280,000 0.8 year

$700,000 2.8 years

3. Investment = Annual cash flow Payback period= $192,000 4

= $768,000

4. Annual cash flow =periodPayback

Investment

=2.5

$325,000

= $130,000 per year

Exercise 1427

1. Initial investment (Average depreciation = $480,000):


incomenetAverage

=$2,400,000

$480,000)$3,200,0000($4,000,00 --

= 13.3%

2. Accounting rate of return (ARR):

Project A: ARR =$30,000

$6,000$19,200- = 44%

Project B: ARR =$30,000

$6,000$11,400 -= 18%

Project A should be chosen.

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Exercise 1427 (Concluded)

3. ARR =investmentInitial

incomenetAverage

0. 40 =

$160,000

Initial investment

Initial investment =0.40

$160,000

= $400,000

4. ARR =Investment

incomenetAverage

0.25 =$100,000

incomenetAverage

Average net income = 0.25 $100,000= $25,000

Exercise 1428

1. NPV = PI= (5.65022 $360,000)$2,040,000= $(5,921)

The system should not be purchased.

2. NPV = PI= (4.62288 $36,000)$120,000 = $46,424

Yes, she should make the investment.

3. NPV = PII = PNPVI = (5.33493 $15,000)$7,100

= $72,924

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Exercise 1429

1. P= CF(df) = Ifor the IRR, thus,

df =flowcashAnnual

Investment

=$2,000,000

$6,254,000

= 3.127

For five years and a discount factor of 3.127, the IRR is very close to 18%.Thus, the equipment should be purchased.


df =160,000

$834,560

= 5.216

For 10 years and a discount factor of 5.216, the IRR is very close to 14%. Yes,the investment should be made.

3. CF(df)= Ifor the IRR, thus,

CF=df

I=

$2,880,000

3.85926= $746,257.

Exercise 1430

1. Limpio equipment:


0 $(500,000) 1.00000 $(500,000)1 300,000 0.89286 267,8582 250,000 0.79719 199,2983 200,000 0.71178 142,3564 100,000 0.63552 63,5525 50,000 0.56743 28,372

NPV $ 201,436

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Salman equipment:


0 $(500,000) 1.00000 $(500,000)1 50,000 0.89286 44,6432 50,000 0.79719 39,8603 300,000 0.71178 213,5344 400,000 0.63552 254,2085 450,000 0.56743 255,344

NPV $ 307,589

2. CF(df)I = NPVCF(3.60478)$500,000 = $307,589

(3.60478)CF = $807,589

CF = 3.60478

$807,589

CF = $224,033 per year

Thus, the annual cash flow must exceed $224,036 to be selected.

Exercise 1431

1. Payback period =inflowcashAnnual

investmenOriginal

=$600,000$780,000

$480,000-

=$180,000

$480,000

= 2.67 years

2. Initial investment (Average depreciation = $96,000):


incomeaccountingAverage

=$480,000

$96,000$180,000-

= 17.5%

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3. Year Cash Flow Discount Factor Present Value

0 $(480,000) 1.00000 $(480,000)1 180,000 0.90909 163,636

2 180,000 0.82645 148,7613 180,000 0.75131 135,2364 180,000 0.68301 122,9425 180,000 0.62092 111,766

NPV $ 202,341

Or NPV = (3.79079 180,000)$480,000 = $202,342*

*Difference is due to rounding.


df =flowcashAnnual

Investment

=180,000

$480,000

= 2.66667

For five years and a discount factor of 2.66667, the IRR is between 20% and25% (much closer to 25%).

Exercise 1432

1. Payback period:

Project A:

$ 3,000 1.00 year4,000 1.00 year3,000 0.60 year

$10,000 2.60 years

Project B:

$ 3,000 1.00 year

4,000 1.00 year3,000 0.50 year

$10,000 2.50 years

Both projects have about the same payback so the most profitable should bechosen (Project A).

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2. Accounting rate of return (ARR):

Project A: ARR =$10,000

$2,000$6,400 -= 44%

Project B: ARR =$10,000

$2,000$3,800 -= 18%

Project A should be chosen.

3. P= 9.81815 $24,000 = $235,636

Wilma should take the annuity.

4. NPV = PI

= (4.62288 $6,000)$20,000 = $7,737Yes, he should make the investment.

5. df=$25,000

$130,400= 5.216

IRR is very close to 14%

Yes, the investment should be made.

Exercise 1433

1. a. Return of the original investment $100,000

b. Cost of capital ($100,000 10%) 10,000

c. Profit earned on the investment($115,500$110,000) 5,500

Present value of profit:

P = F Discount factor= $5,500 0.90909= $5,000

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0 $(100,000) 1.00000 $(100,000)1 115,500 0.90909 105,000

Net present value $ 5,000

Net present value gives the present value of future profit.

Exercise 1434

1. P= I= df CF2.91371* CF= $120,000

CF= $41,185

*From Exhibit 14B-2, 14% for 4 years.

2. For IRR (discount factors from Exhibit 14B-2):

I = df CF= 2.40183 CF(1)

For NPV:NPV = df CFI

= 2.57710 CFI(2)

Substituting equation (1) into equation (2):

NPV = (2.57710 CF)(2.40183 CF)

$1,750 = 0.17527 CF

CF =$1,750

0.17527

= $9,985 in savings each year

Substituting CF = $9,985 into equation (1):I = 2.40183 $9,985

= $23,982 original investment

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3. For IRR:

I = df CF$60,096 = df $12,000

df =$12,000$60,096

= 5.008

From Exhibit 14B-2, 18% column, the year corresponding to df= 5.008 is 14.Thus, the lathe must last 14 years.

4. X = Cash flow in year 4

Investment = 2X


0 $ (2X) 1.00000 $ (2X)1 10,000 0.90909 9,0912 12,000 0.82645 9,9173 15,000 0.75131 11,2704 X 0.68301 0.68301X

NPV $ 3,927

2X + $9,091 + $9,917 + $11,270 + 0.68301X = $3,9271.31699X + $30,278 = $3,927

1.31699X = $(26,351)X = $20,009

Cash flow in year 4 = X = $20,000

Cost of project = 2X = $40,000

Exercise 1435

1. NPV:

Project I


0 $(100,000) 1.00000 $(100,000)1 2 134,560 0.82645 111,207

NPV $ 11,207

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Project II


0 $(100,000) 1.00000 $(100,000)1 63,857 0.90909 58,0522 63,857 0.82645 52,775

NPV $ 10,827

Project I should be chosen using NPV.

IRR:

Project I

I = df CF

$100,000 =2i)(1

$134,560

(1 + i)2 =$100,000

$134,560

= 1.34561 + I = 1.16IRR = 16%

Project II

df =CP

I

=$63,857

$100,000

= 1.566

From Exhibit 14B-2, IRR is very close to 18%.

Project II should be chosen using IRR.

2. NPV is an absolute profitability measure and reveals how much the value ofthe firm will change for each project; IRR gives a measure of relativeprofitability. Thus, since NPV reveals the total wealth change attributable to

each project, it is preferred to the IRR measure.

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PROBLEMS

Problem 1436

1. Schedule of cash flows:

Year Item Cash Flow

0 Equipment $(300,000)Working capital (30,000)

17 Cost savings $135,000Equipment operating costs (60,000) 75,000

5 Overhaul (30,000)7 Salvage value 24,000

Recovery of working capital 30,000

2. NPV:


0 $(330,000) 1.00000 $(330,000)17 75,000 4.86842 365,1325 (30,000) 0.62092 (18,628)7 54,000 0.51316 27,711

NPV $ 44,215

Yes, the new process design should be accepted.

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Problem 1437

1. Schedule of cash flows:

Year Item Cash Flow

0 Equipment $(1,100,000)Working capital (50,000)

Total $(1,150,000)

15 Revenues $ 1,500,000Operating expenses (1,260,000)

Total $ 240,000

6 Revenues $ 1,500,000Operating expenses (1,260,000)Major maintenance (100,000)

Total $ 140,000

79 Revenues $ 1,500,000Operating expenses (1,260,000)Total $ 240,000

10 Revenues $ 1,500,000Operating expenses (1,260,000)Salvage 40,000Recovery of working capital 50,000

Total $ 330,000


0 $(1,150,000) 1.00000 $(1,150,000)15 240,000 3.60478 865,1476 140,000 0.50663 70,9287 240,000 0.45235 108,5648 240,000 0.40388 96,9319 240,000 0.36061 86,54610 330,000 0.32197 106,250

NPV $ 184,366

The new process should be accepted.

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Problem 1438

1. df =flowcashAnnual

Investment

=$20,000

$96,660

= 4.833

The IRR is essentially 16%. The company should acquire the new system.

2. Since I= Pfor the IRR:

I= df CF$96,660 = 6.14457* CF

6.14457 CF= $96,660CF= $15,731

*Discount factor at 10% (cost of capital) for 10 years.

3. For a life of 8 years:

df =CF

I

=$20,000

$96,660

= 4.833

The IRR is between 12% and 14%greater than the 10% cost of capital. Thecompany should still acquire the new system.

Minimum cash flow at 10% for 8 years:

I= df CF$96,660 = 5.33493 CF

5.33493 CF= $96,660CF= $18,118

4. Requirement 2 reveals that the estimates for cash savings can be off by asmuch as $4,269 (over 20%) without affecting the viability of the new system.Requirement 3 reveals that the life of the new system can be two years lessthan expected and the project is still viable. In the latter case, the cash flows

can also decrease by almost 10% as well without changing the outcome. Thus,the sensitivity analysis should strengthen the case for buying the new system.

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Problem 1439

1. First, calculate the expected cash flows:

Days of operation each year: 36515 = 350Revenue per day: $200 2 150 = $60,000

Annual revenue: $60,000 350 = $21,000,000

Annual cash flow = RevenuesOperating costs= $21,000,000$2,500,000= $18,500,000

NPV = PI= (6.62313 $18,500,000)$100,000,000= $122,527,905$100,000,000= $22,527,905

Yes, the aircraft should be purchased.

2. Revised cash flow = (0.80 $21,000,000)$2,500,000= $14,300,000

NPV = PI= (6.62313 $14,300,000)$100,000,000= $(5,289,241)

No, the aircraft should not be purchased.

3. NPV = (6.62313)CF$100,000,000 = 0

CF=$100,000,000

6.62313

= $15,098,601

Annual revenue = $15,098,601 + $2,500,000= $17,598,601

Daily revenue =$17,598,601

350

= $50,282

Seats to be sold =$50,282

$400

= 126 seats (each way)

Seating rate needed =150

126= 84%

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Problem 1439 (Concluded)

4. Seats to be sold =$50,282

$440= 115 (rounded up)

Seating rate =150

115= 77%

This seating rate is less than the most likely and above the least likely rate of70%. There is some risk, since it is possible that the actual rate could be below77%. However, the interval is 20% (70% to 90%), and the 77% rate is only 35%of the way into the interval, suggesting a high probability of a positive NPV.

Problem 1440

1. 1.00 year $16,800

1.00 year 24,0001.00 year 29,4000.13 year* 3,8003.13 years $74,000

*$29,400

$3,800

Note: Cash flow = Increased revenue less cash expenses of $3,000.

2. Accounting rate of return:

Average cash revenue =

($19,800 + $27,000 + $32,400 + $32,400)

4 = $27,900

Average cash expenses = $3,000 per year

Average depreciation =4

$6,000$74,000-= $17,000

Accounting rate of return =$74,000

$17,000)$3,000($27,900 --

=$74,000

$7,900

= 10.68%

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0 $(74,000) 1.00000 $(74,000)1 16,800 0.89286 15,000

2 24,000 0.79719 19,1333 29,400 0.71178 20,9264 35,400* 0.63552 22,497

NPV $ 3,556

*Includes $6,000 salvage.

IRR (by trial and error):

Using 14% as the first guess:


0 $(74,000) 1.00000 $(74,000)1 16,800 0.87719 14,7372 24,000 0.76947 18,4673 29,400 0.67497 19,8444 35,400 0.59208 20,960

NPV $ 8

The IRR is about 14%.

The equipment should be purchased (the NPV is positive and the IRR is largerthan the cost of capital). Dr. Avard should not be concerned about theaccounting rate of return in making this decision. The payback, however, maybe of some interest, particularly if cash flow is of concern to Dr. Avard.


0 $(74,000) 1.00000 $(74,000)1 11,200 0.89286 10,0002 16,000 0.79719 12,7553 19,600 0.71178 13,9514 25,600 0.63552 16,269

NPV $(21,025)

For years 14, the cash flows are 2/3 of the original cash flow increases. Year4 also includes $6,000 salvage.

Given the new information, Dr. Avard should not buy the equipment.

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Problem 1441

1. Annual CF(rebuild alternative) = ($295$274.65)10,000 = $203,500NPV = (CF df)I= ($203,500 3.79079)$600,000 = $171,426

Annual CF(scrap alternative) = $4 10,000 = $40,000

NPV = (CF df)I= ($40,000 3.79079)$0 = $151,632

The NPV of the rebuild alternative is greater and so the new demag machineshould be purchased.

2. For the rebuild alternative, d f=$600,000

$203,500= 2.94840. The IRR is 14%. For the

scrap alternative, df CF= 0 implies that the IRR is infinite (CFis $40,000 andso df = 0 is required, which can occur only if the discount rate approachesinfinity). This means that the scrap alternative is better under the IRR criterion.However, this doesnt make sense because an infinite IRR is required even if

the annual cash flow is $1 per year! Clearly, the NPV approach is better as itmeasures the absolute improvement in dollars.

Problem 1442

1. Project Investment Allocation

(1) Substance abuse wing $1,500,000 $1,500,000(2) Laboratory 500,000 0(3) Outpatient surgery wing 1,000,000 0

Total net present value realized = $150,000

2. With unlimited capital, the substance abuse wing and the laboratory would bechosen. With limited capital the laboratory and outpatient surgery wing wouldbe chosen.

3. Three qualitative considerations that should generally be considered in capitalbudgeting evaluations include:

Quicker response to market changes and flexibility in production capacity.

Strategic fit and long-term competitive improvement from the project, or thenegative impact to the companys competitiveness or image if it does not

make the investment.

Risks inherent in the project, business, or country for the investment.

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Problem 1443

1. Payback period =inflowcashAnnual

investmenOriginal

= $3,000,000$3,900,000

$3,500,000

-

=$900,000

$3,500,000

= 3.89 years


0 $(3,500,000) 1.00000 $(3,500,000)1 900,000 0.90909 818,181

2 900,000 0.82645 743,8053 900,000 0.75131 676,1794 900,000 0.68301 614,7095 900,000 0.62092 558,828

NPV $ (88,298)

P= CF(df) = Ifor the IRR, thus,

df =flowcashAnnual

Investment

=$900,000

$3,500,000

= 3.88889

For five years and a discount factor of 3.88889, the IRR is about 9%.

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3. Year Cash Flow* Discount Factor Present Value

0 $(3,500,000) 1.00000 $(3,500,000)1 945,000 0.90909 859,090

2 992,250 0.82645 820,0453 1,041,863 0.75131 782,7624 1,093,956 0.68301 747,1835 1,148,654 0.62092 713,222

NPV $ 422,302

*(1.05)n $900,000, n= 1, 2, , 5. The asterisk is for years one through five.

It is very important to adjust cash flows for inflationary effects. Since therequired rate of return for capital budgeting analysis reflects an inflationarycomponent at the time NPV analysis is performed, a correct analysis alsorequires that the predicted operating cash flows be adjusted to reflectinflationary effects. If the operating cash flows are not adjusted, then anerroneous decision may be the outcome. Notice, for example, that afteradjusting for inflation, the new system is now favoreda totally differentdecision.

Problem 1444

1. Bond cost =$60,000

$3,000= 0.05

Cost of capital = 0.05(0.6) + 0.175(0.4)= 0.03 + 0.07= 0.10


0 $(100,000) 1.00000 $(100,000)1 50,000 0.90909 45,4552 50,000 0.82645 41,3233 50,000 0.75131 37,566

NPV $ 24,344

It is not necessary to subtract the interest payments and the dividendpayments because these are associated with the cost of capital and areincluded in the firms cost of capital of 10%.

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Problem 1445

1. Original savings and investment:

(14% rate):

Year CF df Present Value

0 $(45,000,000) 1.00000 $(45,000,000)120 4,000,000 6.62313 26,492,52020 5,000,000 0.07276 363,800

NPV $(18,143,680)

(20% rate):


0 $(45,000,000) 1.00000 $(45,000,000)120 4,000,000 4.86958 19,478,32020 5,000,000 0.02608 130,400

NPV $(25,391,280)

2. Total benefits: ($4,000,000 + $1,000,000 + $2,400,000)

(14% rate):


0 $(45,000,000) 1.00000 $(45,000,000)120 7,400,000 6.62313 49,011,16220 5,000,000 0.07276 363,800

NPV $ 4,374,962

(20% rate):


0 $(45,000,000) 1.00000 $(45,000,000)120 7,400,000 4.86958 36,034,89220 5,000,000 0.02608 130,400

NPV $ (8,834,708)

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3. Analysis with increased investment:

(14% rate):


0 $(48,000,000) 1.00000 $(48,000,000)120 7,400,000 6.62313 49,011,16220 5,000,000 0.07276 363,800

NPV $ 1,374,962

(20% rate):


0 $(48,000,000) 1.00000 $(48,000,000)120 7,400,000 4.86958 36,034,89220 5,000,000 0.02608 130,400

NPV $ 1,374,962

4. The automated plant is an attractive investment when the additional benefitsare consideredit promises to return at least the cost of capital (even for thehigh-cost scenario). Using the hurdle rate of 20% is probably tooconservativeespecially given the robustness of the outcome using the costof capital. The company should invest in the new system.

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Problem 1446


0 $(860,000) 1.00000 $(860,000)18 225,000 4.34359 977,308

NPV $ 117,308


0 $(920,000) 1.00000 $(920,000)18 205,000 4.34359 890,436

NPV $ (29,564)

After the fact, the decision was not a good one.

3. The $60,000 per year is an annuity that produces a present value of $260,615(4.34359 $60,000). This restores the project to a positive NPV position

($260,615$29,564 = $231,051).

4. A postaudit can help ensure that a firms resources are being used wisely. Itmay reveal that additional resources ought to be invested or that correctiveaction be taken so that the performance of the investment is improved. Apostaudit may even signal the need to abandon a project or replace it with amore viable alternative. Postaudits also provide information to managers sothat their future capital decision making can be improved. Finally, postauditscan be used as a means to hold managers accountable for their capitalinvestment decisions.

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Problem 1447

1. Standard equipment (Rate = 18%):


0 $(500,000) 1.00000 $(500,000)1 300,000 0.84746 254,2382 200,000 0.71818 143,636

310 100,000 2.92845 292,845NPV $ 190,719

CAM equipment (Rate = 18%):


0 $(2,000,000) 1.00000 $(2,000,000)1 100,000 0.84746 84,7462 200,000 0.71818 143,636

3 300,000 0.60863 182,58946 400,000 1.32333 529,3327 500,000 0.31393 156,965

810 1,000,000 0.68256 682,560NPV $ (220,172)



0 $(500,000) 1.00000 $(500,000)1 300,000 0.90909 272,727

2 200,000 0.82645 165,290310 100,000 4.40903 440,903NPV $ 378,920



0 $(2,000,000) 1.00000 $(2,000,000)1 100,000 0.90909 90,9092 200,000 0.82645 165,2903 300,000 0.75131 225,393

46 400,000 1.86840 747,360

7 500,000 0.51316 256,580810 1,000,000 1.27615 1,276,150NPV $ 761,682

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3. Notice how the cash flows using a 10% rate in years 810 are weightedcompared to the 18% rate. The difference in present value is significant. Usingan excessive discount rate works against those projects that promise large

cash flows later in their lives. The best course of action for a firm is to use itscost of capital as the discount rate. Otherwise, some very attractive andessential investments could be overlooked.

Problem 1448



0 $(500,000) 1.00000 $(500,000)1 300,000 0.87719 263,1572 200,000 0.76947 153,894

310 100,000 3.56946 356,946NPV $ 273,997



0 $(2,000,000) 1.00000 $(2,000,000)1 100,000 0.87719 87,7192 200,000 0.76947 153,8943 300,000 0.67497 202,491

46 400,000 1.56704 626,8167 500,000 0.39964 199,820

810 1,000,000 0.92781 927,810NPV $ (198,550)



0 $(500,000) 1.00000 $(500,000)1 300,000 0.87719 263,1572 200,000 0.76947 153,894

310 50,000 3.56946 178,473NPV $ 95,524

The decision reversesthe CAM system is now preferable. This reversal isattributable to the intangible benefit of maintaining market share. To remaincompetitive, managers must make good decisions, and this exerciseemphasizes how intangible benefits can affect decisions.

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CASES

Case 1449

The statement that Manny would normally have taken the first bid without

hesitation implies that the bid met all of the formal requirements outlined by thecompany. If Mannys friend had met the bid as requested, then presumablyManny would have offered the business to his friend. The motive for this wasfriendship and possibly carried with it past experience in dealing with Toddscompany. Perhaps there was some uncertainty in Mannys mind about the lowbidders ability to execute the requirements of the bid, especially since thewinning bid was from out of state. If there was some legitimate concern about thewinning bid and Manny was hopeful of eliminating this concern by dealing with aknown quantity, then it could be argued that the call to Todd was justifiable. If, onthe other hand, the only motive was friendship and Manny was confident that thewinning bid could execute (as he appears to have been), then the call was

improper. Confidentiality and integrity in carrying out the firms bidding policiesare essential.

The fact that Manny was tempted by Todds enticements and appeared to beleaning toward accepting Todds original offer compounds the difficulty of theissue. If Manny actually accepts Todds offer and grants the business at theoriginal price and accepts the gifts, then his behavior is unquestionablyunethical. Some of the standards of ethical conduct that would be violated arelisted below.

II. Confidentiality

1. Keep information confidential except when disclosure is authorized orlegally required.

3. Refrain from using confidential information for unethical or illegaladvantage.

III. Integrity

2. Refrain from engaging in any conduct that would prejudice carrying outduties ethically.

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Case 1450

1. Shaftel Ready MixIncome Statement

For the Year Ended 20XX

Sales (35,000 $45) .............................................. $1,575,000Less: Variable expenses ($35.08 35,000) ......... 1,227,800Contribution margin ............................................. $ 347,200Less fixed expenses:

Salaries ............................................................. $135,000Insurance.......................................................... 75,000Telephone......................................................... 5,000Depreciation ..................................................... 56,200*Utilities ............................................................. 25,000 296,200

Net income ............................................................ $ 51,000

*Reported depreciation erroneously included $2,000 for the land.

Ratio of net income to sales =$1,575,000

$51,000= 3.24%

Karl is correct that the return on sales is significantly lower than the companyaverage.

2. Payback period =flowcashAnnual

investmenOrignal

= *$107,200

$352,000

= 3.28 years

*Net income of $51,000 + depreciation of $56,200

Karl is not right. The book value of the equipment and the furniture should notbe included in the amount of the original investment because there is noopportunity cost associated with them. Excluding the book value reduces theinvestment from $582,000 to $352,000. Karls payback would be correct if theequipment and furniture could be sold for their book value because therewould now be an opportunity cost associated with them and that cost should

be included in the original investment.

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Case 1450 (Continued)

3. NPV:


0 $(352,000) 1.00000 $(352,000)110 107,200 6.14457 658,698NPV $ 306,698

IRR:

df =CF

I

=$107,200

$352,000

= 3.28358

Thus, the IRR is between 25 percent and 30 percent.If the furniture and equipment can be sold for book value:

NPV:


0 $(582,000) 1.00000 $(582,000)110 107,200 6.14457 658,698NPV $ 76,698

IRR:

df =$107,200$582,000

= 5.42910

Thus, the IRR is between 12 percent and 14 percent.

4. Break even:

$45X = $35.08X + $296,200$9.92X = $296,200

X = 29,859 cubic yards

NPV (using break-even amount):Year Cash Flow Discount Factor Present Value

0 $(352,000) 1.00000 $(352,000)110 56,200 6.14457 345,325NPV $ (6,675)

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1450 (Concluded)

IRR:

df =$56,200

$352,000

= 6.2633

Thus, the IRR is between 9 percent and 10 percent.

The investment is not acceptable, although it came close. It is possible to havea positive NPV at the break-even point. Break-even is defined for accountingincome, not for cash flow. Since there are noncash expenses deducted fromrevenues, accounting income understates cash income. Zero income does notmean zero cash inflows.

5. Cost of capital = 10 percent for 10 years, so df= 6.14457

df =CF

I

6.14457 =CF

$352,000

6.14457 CF = $352,000

CF = $57,286

Cash flow $57,286Less: Depreciation 56,200

Net income $ 1,086

Net income = SalesVariable expensesFixed expenses$1,086 = $45X$35.08X$296,200$1,086 = $9.92X$296,200

$297,286 = $9.92XX = 29,968 cubic yards

Sales $1,348,560Less: Variable expenses 1,051,277Contribution margin $ 297,283Less: Fixed expenses 296,200

Net income $ 1,083**Difference due to rounding

Acct 260 Chapter 14

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