CHAPTER 11 CAPITAL BUDGETING The following tables are needed to complete problems requiring present value computations. Students may also use a calculator or computer spreadsheet program, but the answers to the multiple choice may change due to rounding errors. Warning: Two comprehensive problems are prefaced by (Additional PV information is needed to complete this problem.) when these tables are insufficient for completion. Present value of $1 Present value of an annuity of $1 Period 5% 10% 15% 20% Period 5% 10% 15% 20% 5 0.7835 0.6209 0.4972 0.4019 5 4.3295 3.7908 3.35222.9906 10 0.6139 0.3855 0.2472 0.1615 10 7.7217 6.1446 5.01884.1925 20 0.3769 0.1486 0.0611 0.0261 20 12.4622 8.5136 6.25934.8696 Future value of $1 An nuity required to repay an amount of $1 Period 5% 10% 15% 20% Period 5% 10% 15% 20% 5 1.2763 1.6105 2.0114 2.4883 5 0.2310 0.2638 0.29830.3344 10 1.6289 2.5937 4.0456 6.1917 10 0.1295 0.1627 0.19930.2385 20 2.6533 6.7275 16.3665 38.3376 20 0.0802 0.1175 0.15980.2054 TRUE/FALSE 1. Employee training costs should be evaluated as long-term investments. a. True b. False 2. Long-term asset acquisitions are evaluated to determine whether future benefits justify the initial cost. a. True b. False AKY 4E Test Bank Chapter 11 Page 1 Schoenebeck
Transcript
CHAPTER 11CAPITAL BUDGETING
The following tables are needed to complete problems requiring present value computations. Students may also use a calculator or computer spreadsheet program, but the answers to the multiple choice may change due to rounding errors.
Warning: Two comprehensive problems are prefaced by (Additional PV information is needed to complete this problem.) when these tables are insufficient for completion.
Present value of $1 Present value of an annuity of $1Period 5% 10% 15% 20% Period 5% 10% 15% 20% 5 0.7835 0.6209 0.4972 0.4019 5 4.3295 3.7908 3.3522 2.9906
Future value of $1 An nuity required to repay an amount of $1 Period 5% 10% 15% 20% Period 5% 10% 15% 20% 5 1.2763 1.6105 2.0114 2.4883 5 0.2310 0.2638 0.2983 0.3344
1. Employee training costs should be evaluated as long-term investments.a. Trueb. False
2. Long-term asset acquisitions are evaluated to determine whether future benefits justify the initial cost.a. Trueb. False
3. Money received in the future is more valuable than it is now.a. Trueb. False
4. Robert wants to invest in a certificate of deposit that pays out $4,000 in four years. If interest rates increase, the required initial investment will also increase.a. Trueb. False
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5. The future value of $100 is greater than its present value.a. Trueb. False
6. Future value is calculated for time zero.a. Trueb. False
7. A bond that pays 8% interest will sell at a premium in a 10% market.a. Trueb. False
8. The cost of capital reflects the degree of financial and operating risk to the organization.a. Trueb. False
9. If a company’s cost of capital is 15%, a net present value of $10 indicates an acceptable capital project.a. Trueb. False
10. Choosing the greatest net present value is always the best decision choice.a. Trueb. False
11. When using net present value and a 12% discount rate results in an acceptable project, then a 9% discount rate will also result in that same project being acceptable.a. Trueb. False
12. The net present value method is considered superior to the internal rate of return for evaluating capital projects.a. Trueb. False
13. The internal rate of return method assumes the organization can reinvest a project’s intermediate cash flows at the project’s internal rate of return.a. Trueb. False
14. The payback method does not consider the time value of money and, therefore, is rarely used in practice.a. Trueb. False
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15. If a company’s cost of capital is 12%, a net present value of $1 indicates the project’s actual rate of return exceeds 12%.a. Trueb. False
16. The profitability index provides comparison information for projects with different initial investments.a. Trueb. False
17. Economic value added is best suited for evaluating new capital projects.a. Trueb. False
18. Depreciation reduces income and, therefore, helps reduce the income taxes of an organization.a. Trueb. False
19. To account for inflation, discount the cash flow by the appropriate discount rate and the expected inflation rate.a. Trueb. False
20. Capital budgeting estimates are usually more accurate for new projects.a. Trueb. False
21. If a capital project is projected to return less than the cost of capital, it may still be implemented for strategic reasons.a. Trueb. False
22. Post-implementation audits help ensure planning groups use reasonable estimates.a. Trueb. False
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MULTIPLE CHOICE
23. The purchase of long-term assets results in all of the following EXCEPT:a. the creation of committed resourcesb. the creation of unit-related costsc. additional risk for the organizationd. reduced organizational flexibility
24. An organization must approach long-term investments cautiously because of all of the following EXCEPT that:a. the long-term nature creates technological riskb. invested amounts are committed for an extended period of timec. the value of money decreases with timed. a large amount of capital is usually invested
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 25 THROUGH 27.Carol invests $10,000 in a 2-year certificate of deposit (CD) that will earn a 6% annual rate of return compounded annually.
25. At the end of the two years, the future value of the CD is:a. $10,000b. $10,600c. $11,200d. $11,236
26. The rate of return on this investment is:a. 6%b. 12%c. 12.36%d. None of the above is correct.
27. The difference between the present value and the future value of this investment is:a. the annuity of the investmentb. interest earned on the investmentc. the investment rate of returnd. the cash inflows from the investment
28. For the purchase of a boat, motor, and trailer, Steven needs to accumulate $25,000 at the end of two years. His initial investment will earn 8% annual interest compounded semiannually. For this investment:a. the number of compounding periods is 2b. the interest earned per compounding period is 4%c. $25,000 is the present valued. the rate of return is 16%
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29. Investments A and B both have a future value of $5,000 and are exactly the same except that Investment A has a 5% rate of return while Investment B has an 8% rate of return. The present value of Investment A will be __________ the present value of Investment B.a. less thanb. the same asc. greater thand. can’t tell
30. Investments A and B both have a future value of $5,000 and are exactly the same except that Investment A matures in 5 years while Investment B matures in ten years. The present value of Investment A will be __________ the present value of Investment B.a. less thanb. the same asc. greater thand. can’t tell
31. A lottery pays the winner $100,000 per year for 20 years. The present value of this prize money is:a. greater than $2,000,000b. $2,000,000c. less than $2,000,000d. indeterminable
32. The cost of capital: a. reflects the perceived level of risk that investors requireb. is used to calculate the accounting rate of returnc. is used to calculate future valued. is another term for the rate of return
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 33 AND 34.An investor wants to have $25,000 in an account at the end of 25 years. At current interest rates, $5,000 needs to be deposited now to reach the goal of $25,000.
33. What is the present value of this investment?a. $1,000b. $5,000c. $25,000d. More information is needed to determine the amount.
34. Assume interest rates increase before the investment is made. To reach the same goal of $25,000 in 25 years, the investor will have to deposit:a. more than $5,000b. $5,000c. less than $5,000d. More information is needed to determine the amount of the deposit.
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35. You have been offered the following two annuities for the same price: Annuity 1 pays $20,000 per year for 10 years; and Annuity 2 pays $40,000 per year for 5 years. Which of these two annuities offers a greater value?a. They are of equal value because both pay $200,000 over the life of the annuity.b. Annuity 2 is of greater value because the payments are received sooner.c. Annuity 1 is of greater current value because the payments are received over a longer
period of time.d. The value cannot be determined without proper present value analysis.
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 36 THROUGH 39.A bond with a face value of $10,000 pays $600 in interest every six months for 10 years and a lump sum of $10,000 at the end of the tenth year. The current market requires 10% interest compounded semiannually.
36. What is the present value of the $10,000 payment at the end of the tenth year?a. $ 1,486b. $ 3,769c. $ 3,855d. $61,446
37. The $600 semiannual interest payments: a. are an example of an annuityb. have a present value of $12,000c. reflect the actual rate of interest received by the investord. are all paid at time zero
38. What is the present value of the $600 semiannual interest payments?a. $12,000b. $3,687c. $4,626d. $7,477
39. What would an investor be willing to pay now for this $10,000 bond?a. More than $10,000b. $10,000c. Less than $10,000d. More information is needed to determine the amount.
40. All of the following use the time value of money to evaluate long-term investments EXCEPT:a. the payback methodb. the net present value methodc. the internal rate of returnd. the profitability index
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41. Assume a capital project requires $42,000 as an initial investment and expects a net cash inflow of $12,000 per year. The payback period method:a. would consider the capital project acceptable if the company requires a minimum
payback period of three yearsb. is usually used as a screening device to eliminate capital projects from further
investigationc. uses accounting net income rather than cash flows in the calculationsd. compares the rate of return to the company’s cost of capital
42. The accounting rate of return:a. considers the time value of moneyb. ignores cash outflows after the initial investmentc. incorporates the timing of cash flowsd. utilizes depreciation for the calculation of average income
43. The net present value (NPV) capital budgeting decision method:a. can be directly compared between alternativesb. incorporates the time value of money in the calculationsc. is based on accounting net incomed. indicates an acceptable capital project with a negative value
44. A net present value of $1,000:a. indicates the capital project’s rate of return exceeds the company’s cost of capitalb. for one project is considered superior to another project with a net present value of
$500c. indicates the internal rate of return would be unacceptabled. indicates cash inflows total $1,000 for the capital project
45. Project A: present value (PV) of the cash inflows is $55,000 and the PV of the cash outflows is $50,000. Project B: PV of the cash inflows is $24,000 and the PV of the cash outflows is $20,000. All of the following are true EXCEPT:a. the net present value of Project A is $5,000b. the net present value of Project B is $4,000c. the profitability index for Project A is 1.1d. Project A is a better investment than Project B
46. A 16% internal rate of return (IRR) indicates all of the following EXCEPT:a. the actual rate of return of all cash inflows and outflowsb. that a 16% discount rate will result in the calculation of a net present value of zeroc. a better indication of acceptable capital projects when there is limited capital than the
net present value methodd. an acceptable capital project if the cost of capital is 12%
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47. Which of the following indicates an UNACCEPTABLE capital project?a. The internal rate of return exceeds the cost of capital.b. The net present value of a project is 10.c. The profitability index of a project is 0.97.d. The accounting rate of return exceeds the target rate of return.
48. __________ is best for comparing mutually exclusive projects of different sizes.a. The payback methodb. The net present value methodc. The internal rate of returnd. The profitability index
49. Economic value added: a. is most widely used to evaluate new capital investmentsb. in practice is similar to net present value but it uses accounting income rather than
cash flows in the evaluationc. determines the actual rate of return of all cash inflows and outflowsd. is similar to the internal rate of return but it corrects for the conservative bias
50. Hitz Corporation is financed 60% by debt with a pretax cost of 10%, and 40% by common equity with a pretax cost of 15%. Hitz Corporation’s marginal tax rate is 50%. Hitz’s weighted average cost of capital is:a. 9.0%b. 10.0%c. 12.0%d. 12.5%
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 51 THROUGH 55.Crittenden Company is considering two mutually exclusive investments in capital equipment that have a 10% cost of capital. Cash flow information for the two alternatives is below.
Investment 1 Investment 2Initial investment in equipment $110,000 $170,000Increase in annual cash flows $ 20,000 $ 30,000Life of equipment 10 years 10 yearsSalvage value of equipment 0 0
51. Determine the present value of the initial investment for each alternative.a. $42,405 and $65,535b. $675,906 and $1,044,582c. $1,700,000 and $1,100,000d. None of the above is correct.
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52. Determine the present value of the annual cash flows for each alternative.a. $7,710 and $11,565b. $20,000 and $30,000c. $122,892 and $184,338d. $200,000 and $300,000
53. Compute the net present value for each investment.a. $12,892 and $14,338b. $90,000 and $140,000c. $67,591 and $104,465d. None of the above is correct.
54. Compute the profitability index for each investment.a. 0.895 and 0.922b. 1.117 and 1.084c. 5.500 and 5.667d. None of the above is correct.
55. Which investment would you recommend? a. investment 1 because of the lower initial investmentb. investment 2 because of the greatest annual cash flowsc. investment 1 because of the greatest profitability indexd. investment 2 because of the greatest net present value
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 56 AND 57.Consider the following two mutually exclusive projects, each of which requires an initial investment of $30,000 and both provide cash inflows of $60,000 as shown below. This organization has a 15% cost of capital.
Year Project A Project B0 ($30,000) ($30,000)1 $30,000 $10,0002 20,000 20,0003 10,000 30,000
56. Using the payback criterion, which is the most desirable project?a. Project Ab. Project Bc. Both projects A and B are equally acceptable.d. Neither project A or B is acceptable.
57. Using the net present value criterion, which is the most desirable project?a. Project Ab. Project Bc. Both projects A and B are equally acceptable.d. The desirability cannot be determined using the current information.
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THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 58 AND 59.Davidson Company is now investigating three mutually exclusive investment opportunities. The company’s cost of capital is 10 percent. Information on the three investment projects under study is given below:
----1---- ----2---- ----3----Initial investment $(40,000) $(36,000) $(45,000)Net present value $(2,024) $7,340 $7,297Profitability index 0.95 1.20 1.10Internal rate of return 8% 14% 19%Life of the project 5 yrs 12 yrs 3 yrs
Davidson Company has limited funds available for investment and, therefore, it can’t accept all of the projects listed above.
58. Which projects are acceptable to Davidson?a. investment 2b. investment 3c. investment 2 and 3d. investment 1, 2, and 3
59. Which single investment do you recommend of these three mutually exclusive projects?a. investment 1b. investment 2c. investment 3d. All of these investments could be recommended.
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 60 THROUGH 65.During 2005, a franchise-owned restaurant averaged:
$300,000 in sales;$50,000 in net cash flows; and $30,000 in operating income.
The expected cash investment per franchise-owned restaurant opening in the year 2005 was $250,000. Assume the value of the investment decreases to zero over a ten-year period of time.
60. The payback period for one franchise-owned restaurant is:a. 5.0 yearsb. 8.4 yearsc. 6.0 yearsd. 10.0 years
61. The accounting rate of return for one franchise-owned restaurant is:a. 0.12b. 0.24c. 0.10d. 0.20
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62. Assuming a 10 % required rate of return, the net present value for one franchise-owned restaurant is:a. $19,275b. $11,565c. ($65,662)d. $57,230
63. The profitability index for one franchise-owned restaurant is:a. 1.667b. 0.737c. 1.229d. 0.813
64. The internal rate of return for one franchise-owned restaurant is:a. approximately 15%b. 10%c. greater than 20%d. The IRR cannot be determined.
65. Does this franchise-owned restaurant appear to be a good investment? a. No, because the payback period is too long.b. No, because the expected net annual cash inflows are inadequate.c. Yes, because the investment delivers more than the 10% required rate of return.d. Yes, because the accounting rate of return is greater than 10%.
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 66 THROUGH 71.During 2005, a franchise-owned restaurant averaged:
$200,000 in sales;$75,000 in net cash flows; and $20,000 in operating income.
The expected cash investment per franchise-owned restaurant opening in the year 2005 was $500,000. Assume the value of the investment decreases to zero over a ten-year period of time.
66. The payback period for one franchise-owned restaurant is:a. 6.67 yearsb. 2.67 yearsc. 3.75 yearsd. 10.0 years
67. The accounting rate of return for one franchise-owned restaurant is:a. 0.04b. 0.08c. 0.10d. 0.40
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68. Assuming a 10 % required rate of return, the net present value for one franchise-owned restaurant is:a. $7,710b. $260,845c. ($377,108)d. ($39,155)
69. The profitability index for one franchise-owned restaurant is:a. 2.304b. 0.434c. 0.922d. 1.085
70. The internal rate of return for one franchise-owned restaurant is:a. between 5% and 10%b. 10%c. greater than 20%d. The IRR cannot be determined
71. Does this franchise-owned restaurant appear to be a good investment? a. Yes, because the payback period is less than ten years.b. Yes, because the expected net annual cash inflows provide a good salary.c. No, because the investment delivers less than the 10% required rate of return.d. No, because the accounting rate of return is less than 10%.
72. Taxes of an organization:a. are increased as a result of depreciationb. affect lump-sum payments but not annuitiesc. can best be analyzed by using pretax cash flowsd. usually increase when the net benefit of an investment increases
73. All of the following are true regarding capital budgeting EXCEPT that:a. estimates are not always realizedb. estimating future cash flows is relatively easyc. most estimates are extended projections of past cash flow informationd. estimating circumstances not previously experienced is the hardest
74. The primary use of sensitivity analysis is to determine:a. the effects of a change in a parameter on a decisionb. if the project is too risky to undertakec. the effect of adding or dropping a product lined. which planners make poor estimates
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75. Strategic considerations:a. are fairly easy to determineb. evaluate a firm’s competitive edgec. should not override capital budgeting analysis resultsd. are decreasing in importance
76. Post-implementation audits are all of the following EXCEPT they:a. are useful to identify how future estimates can be improvedb. help ensure planning estimates are reasonablec. are required by a company’s external auditorsd. are conducted after a project has been implemented
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REMINDER!!! Present value tables that are needed to answer the multiple choice questions are located at the beginning of this chapter.
EXERCISE/PROBLEM
77. An investor wants to have $20,000 in an account at the end of 20 years. At current interest rates, $7,000 needs to be deposited now to reach the goal of $20,000.a. What is the present value of this investment?b. Assume interest rates decrease before the investment is made. Will an investment of
$7,000 still result in $20,000 in 20 years? Why or why not?
78. You have been offered the following two annuities for the same price: Annuity 1 pays $50,000 per year for 10 years; and Annuity 2 pays $25,000 per year for 20 years. Which of these two annuities is a better deal? Why?
79. A lottery pays the winner $50,000 per year for 20 years. a. Is the winner receiving a $1,000,000 value? Why or why not?b. Is the winner receiving an annuity? How can you tell?c. Compute the present value of the prize money assuming a 5% discount rate. Explain
what this amount indicates.
80. A bond with a face value of $25,000 pays $1,000 in interest every six months for 10 years and a lump sum of $25,000 at the end of the tenth year. The current market requires 10% interest compounded semiannually.a. What would an investor be willing to pay now for
1. the $25,000 at the end of the tenth year?2. the $1,000 semiannual interest payments?3. the $25,000 bond?
b. Is this bond selling at a premium or a discount? Why?
81. Hitz Corporation is financed 70% by debt with a pretax cost of 10%, and 30% by common equity with a pretax cost of 18%. Hitz Corporation’s marginal tax rate is 40%.a. Calculate Hitz’s weighted average cost of capital.b. How might the cost of capital be used for decision making at Hitz Corporation?
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82. Crittenden Company is considering two mutually exclusive investments in capital equipment that have a 10% cost of capital. Cash flow information for the two alternatives is below.
Investment 1 Investment 2Initial investment in equipment $210,000 $135,000Increase in annual cash flows $ 60,000 $ 40,000Life of equipment 5 years 5 yearsSalvage value of equipment 0 0
a. Determine the present value of the initial investment for each alternative.b. Determine the present value of the annual cash flows for each alternative.c. Compute the net present value for each investment.d. Compute the profitability index for each investment.e. Which investment would you recommend? Why?
83. Stevens Company is contemplating the purchase of a corporate jet. This jet could be either purchased or rented from the manufacturer. The length of the purchase contract is five years. If the jet is purchased, Stevens could sell it at the end of five years for $600,000. The company’s cost of capital is 20%. The data concerning these two alternatives are as follows:
Purchase RentPurchase price $820,000 --Annual cash payments for servicing and licenses 40,000 --Depreciation each year 44,000 --Salvage value at the end of year 5 600,000 --Estimated annual rental payments -- $250,000
a. Compute the net present value of both alternatives.b. Which is the better alternative? Why?
84. Roberts Manufacturing is considering purchasing a piece of equipment costing $65,000, which would create a net cash inflow of $40,000 for five years. The company’s cost of capital is 10% and the tax rate is 40%.
Initial investment in equipment $65,000Increase in annual cash flows $40,000Life of equipment 5 yearsSalvage value of equipment 0
a. Assuming the company uses straight-line depreciation for tax purposes, what is the net present value of purchasing the new equipment, taking income taxes into account?
b. Should Roberts consider this purchase? Why or why not?
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85. Consider the following two mutually exclusive projects, each of which require an initial investment of $100,000 and have no salvage value. This organization, which has a cost of capital of 15%, must choose one or the other.
Year Project A Project B1 $10,000 $50,0002 20,000 40,0003 30,000 30,0004 40,000 20,0005 50,000 10,000
a. Compute the payback period of these two projects. Using the payback criterion, which project is more desirable?
b. What are the advantages and drawbacks of using the payback period criterion to select a capital investment alternative?
c. Straight-line depreciation is used to compute income. Compute the accounting rate of return for these two projects. Using the accounting rate of return criterion, which project is more desirable?
d. What are the advantages and drawbacks of using the accounting rate of return criterion to select a capital investment alternative?
e. Which is the better investment? Why?
86. Davidson Company is now investigating five different investment opportunities. The company’s cost of capital is 10 percent. Information on the five investment projects under study is given below:
----1---- ----2---- ----3---- ----4---- ----5----Initial investment $(48,000) $(36,000) $(27,000) $(45,000) $(40,000)Present value of cash inflows at a 10% discount rate 56,727 43,340 33,614 52,297 37,976Internal rate of return 16% 14% 18% 19% 8%Life of the project 6 yrs 12 yrs 6 yrs 3 yrs 5 yrs
Davidson Company has limited funds available for investment and, therefore, can’t accept all of the projects listed above.
a. Compute the net present value for each investment project.b. Compute the profitability index for each investment project.c. Which projects are acceptable to Davidson? Why?d. Rank the five projects according to preference in terms of:
1. net present value;2. profitability index; and3. internal rate of return.
e. Which investment do you recommend? Why?
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87. (Additional PV information is needed to complete this problem.) Papa John’s International, Inc., has surpassed Little Caesars to become the Number 3 pizza chain, behind Pizza Hut and Domino's, with more than 2,300 restaurants scattered across the U.S. and five other countries. Most restaurants offer delivery or take-out only.
The following information was reported by Papa John’s on the Form 10-K for the fiscal year ended December 26, 1999: For a company-owned restaurant average sales were $754,000; average cash flows were $154,000; and average operating income was $128,000. The expected cash investment per company-owned restaurant opening in the year 2000 is $244,000. Assume the value of the investment decreases to zero over a ten-year period of time.
For one company-owned Papa John’s restaurant, compute the:a. payback period; b. accounting rate of return;c. net present value assuming a 16% required rate of return; andd. internal rate of return.
e. Does a Papa John’s company-owned restaurant appear to be a good investment? Why or why not?
88. (Additional PV information is needed to complete this problem.) Truro Winery is considering the following investment opportunity in a new machine to make Golden Glow, its new apple cider. The investment required is $14,000,000 at the start of year 1 and $10,000,000 at the start of year 2. Starting at the end of year 2, the machine will provide incremental cash inflows of $8,000,000 per year for 12 years. The annual operating expenses associated with the machine will be $3,000,000 each year. If the Truro Winery's after-tax cost of capital is 12% and its marginal tax rate is 30%, compute the following:
a. payback;b. accounting rate of return (assuming straight-line depreciation);c. net present value; and d. internal rate of return.
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CRITICAL THINKING/ESSAY
89. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate investments in long-term assets. Why do these assets deserve this attention?
90. Some people believe that discounted cash flow analysis discriminates against long-term projects because it heavily penalizes cash flows that occur well into the future. Comment.
91. Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15% discount rate to evaluate capital project XYZ?
92. Explain the profitability index and the payback methods used in capital budgeting. Discuss when it would be most appropriate to use each.
93. List two capital budgeting methods that utilize the time value of money and explain how each ranks the performance of different alternatives.
94. Explain how the internal rate of return criterion, if improperly applied, can cause managers to make inappropriate investment decisions.
95. You are considering an investment in a new restaurant chain. You have developed estimates of the initial investment required and the cash flows from that investment. However, you are wondering about the risk of your investment. How might you assess the impact of estimates in your investment decision?
96. An organization is considering investing in an employee-training program. The organization's planners expect that this training program, which would cost $5,000,000, will reduce manufacturing costs and increase the quality of the company's various products. How would you frame this decision in the capital budgeting context?
97. An organization's planners have received a proposal from a manufacturing group to invest in a new production line. The planners are suspicious that the proposal reflects the group's interest in acquiring the latest technology rather than reflecting sound economic evaluation. How might the planners deal with this situation?
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98. Officials at Dundas Manufacturing have just completed a post-implementation audit of a distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group had proposed the warehouse investment arguing that it would improve sales by increasing product quality and improving customer service. The expected rate of return on this investment was 18%, however, the actual return on this investment to date has fallen far below this estimate and it is even below the company's cost of capital of 11%. The post-implementation audit concluded that the managers proposing this investment were ambitious, to the point of being reckless, in making the estimates underlying the project's proposals and argued that the investment should never have been made.
In response, the two managers who proposed the project argue that the proposal was a good one based on estimates that seemed sound at the time. However, several uncontrollable events, including the entry of a new competitor into the market, caused results to be lower than expected. Moreover, the two managers argue that results would have been even worse for the company if the investment had not been made. How would you deal with this situation?
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CHAPTER 11 SOLUTIONSCAPITAL BUDGETING
TRUE/FALSE
LO1 1. aLO3 2. aLO3 3. bLO3 4. bLO3 5. a
LO3 6. bLO3 7. bLO3 8. aLO4 9. aLO4 10. b
LO4 11. bLO4 12. aLO4 13. aLO4 14. bLO4 15. a
LO4 16. aLO4 17. bLO5 18. aLO5 19. aLO6 20. b
LO7 21. aLO8 22. a
MULTIPLE CHOICE
LO1 23. bLO2 24. cLO3 25. d
LO3 26. aLO3 27. bLO3 28. bLO3 29. cLO3 30. c
LO3 31. cLO3 32. aLO3 33. bLO3 34. cLO3 35. b
LO3 36. bLO3 37. aLO3 38. dLO3 39. aLO4 40. a
LO4 41. bLO4 42. dLO4 43. bLO4 44. aLO4 45. d
LO4 46. cLO4 47. cLO4 48. dLO4 49. bLO4 50. a
LO4 51. dLO4 52. cLO4 53. aLO4 54. bLO4 55. c
LO4 56. aLO4 57. aLO4 58. cLO4 59. bLO4 60. a
LO4 61. bLO4 62. dLO4 63. cLO4 64. aLO4 65. c
LO4 66. aLO4 67. bLO4 68. dLO4 69. cLO4 70. a
LO4 71. cLO5 72. dLO6 73. bLO6 74. aLO7 75. b
LO8 76. c
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MULTIPLE CHOICE
25. $10,000 x 1.06 x 1.06 = $11,23636. $10,000 x PVF (5%, 20 periods) 0.3769 = $3,76938. $600 x PVF Annuity (5%, 20 periods) 12.4622 = $7,47745. The profitability index of Project B $24,000 / $20,000 = 1.20, which is greater than the
profitability index of Project A at $55,000 / $50,000 = 1.10
50. Pretax cost After tax cost Weight Weighted averageDebt 10% (1-tax rate) 5% 60% 3.0%Common equity 15% 15% 40% 6.0% Weighted average cost of capital 9.0%
51. Present value is $110,000 and $170,000, respectively52. $20,000 x PVF Annuity (10%, 10 periods) 6.1446 = $122,892
$30,000 x PVF Annuity (10%, 10 periods) 6.1446 = $184,338 - $170,000 = $14,33854. $122,892 / $110,000 = 1.117; $184,338 / $170,000 = 1.08456. Payback is one year for Project A and two years for Project B57. Because Project A receives more cash sooner, the net present value will be greater.58. Investments 2 and 3 report positive net present values, which indicates the return is greater
than the required cost of capital59. Investment 2 because it offers a 14% return over four years, and therefore, the profitability
index of 1.20 is the greatest.60. $250,000 amount invested / $50,000 expected annual net cash inflow = 5.0 payback period61. $30,000 average annual operating income from asset / [($250,000 + 0) / 2] average amount
invested in assets = 0.24 accounting rate of return62. PV of annuity (10-year, 10%) $50,000 x 6.1446 = .........$307,230
Investment....................................................................... (250,000 ) Net present value............................................................$ 57,230
PV annuity factor for (10-year, 10%) = 6.1446 and PV annuity factor for (10-year, 5%) = 7.7217. Therefore, the IRR is between 5% and 10%.
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EXERCISE/PROBLEM
LO377. a. The present value is $7,000.
b. No, an investment of $7,000 will no longer result in $20,000 in 20 years. Due to the lower interest rates, less interest will be earned over the 20 years, therefore, the initial investment now needs to be greater than $7,000. PV + interest earned = FV.
LO378. Even though both annuities pay $500,000 in total, Annuity 1 is the better deal because the
total payback of $500,000 is received 10 years earlier.
LO379. a. No, the lottery winner is not receiving a $1,000,000 value because the entire sum is
not being received now. Because money can earn a return, its value depends on when it is received.
b. Yes, this is an annuity because the winner is receiving the same amount at the end of each year for 20 years.
c. The present value of the prize money is $623,110 = ($50,000 x 12.4622). This indicates that the 20 payments of $50,000 each to be received in the future are only worth $623,110 now, rather than $1,000,000.
LO3 80. a1. Present value of the $25,000 at the end of ten years is $9,423 = $25,000 x 0.3769.
a2. Present value of the $1,000 semiannual interest payments is $12,462 = $1,000 x 12.4622.
a3. Present value of the $25,000 bond is $21,885 = ($9,423 + $12,462).b. This bond is selling at a discount because the bond is only paying 8% ($2,000 per
year / $25,000 face) interest when the market rate is 10%. To achieve the higher yield, the investor pays in less than face value (discounted), but at maturity the investor receives the full $25,000 face value.
LO381. a. Pretax cost After tax cost Weight Weighted average
Debt 10% (1-tax rate) 6% 70% 4.2%Common equity 18% 18% 30% 5.4% Weighted average cost of capital 9.6%
b. Hitz Corporation may use the cost of capital as a benchmark for accepting or rejecting capital investment proposals.
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LO482. Investment 1 Investment 2
a. PV of the initial investment$210,000 $135,000
b. PV of the annual cash flows$227,448 = ($60,000 x 3.7908) $151,632 = ($40,000 x 3.7908)
c. Net present value $17,448 = ($227,448 – $210,000) $16,632 = ($151,632 – $135,000)
d. Profitability index 1.083 = ($227,448 / $210,000) 1.123 = ($151,632 / $135,000)
e. The profitability index indicates that Investment 2 is preferred, while the net present value method does not inherently distinguish between projects with different magnitudes of initial investment. However, the final choice between these two mutually exclusive alternatives may depend on qualitative factors that distinguish between the two alternatives or identify other possible uses for the available funds.
b. Net present value indicates that purchasing the jet is the preferred alternative. However, even though the net present values differ by $49,166, the additional risk of ownership may sway the company to choose to rent on a use-by-use basis.
LO584. a. The net present value is $45,691 when income taxes are taken into account.
Annual cash flow Depreciation Taxable income Tax @ 40% Net cash flow$40,000 $13,000 $27,000 $10,800 $29,200
After-tax net cash flow PV factor of an annuity Present valueInitial investment ($65,000)Annual cash flows $29,200 3.7908 (5yrs, 10%) 110,691 Net present value ($45,691 )
b. Yes, Roberts should consider this purchase because the net present value is positive, which indicates the purchase meets the company’s 10% cost of capital requirement.
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LO485. a. Project A payback period is 4 years.
Project B payback period is 2.33 years = (2 years + $10,000/$30,000)The payback criterion indicates that Project B is the preferred investment because it has the shorter payback period.
b. The advantage of using the payback period criterion is that it gives an indication of the project’s risk, in the sense that the longer the payback period, the longer an organization is exposed to an unrecovered investment. Drawbacks include that it ignores the time value of money and that it ignores cash outflows after the initial investment and cash inflows after the payback period.
c. Project A accounting rate of return is 20% = (*$10,000 average income / **$50,000 average investment).Average increase in income is [(10+20+30+40+50) / 5] = $30,000 per yearDepreciation is $100,000 / 5 years = $20,000 per year* Average income is $10,000 = (Average increase $30,000 – Depreciation $20,000)
** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]
Project B accounting rate of return is 20% = (*$10,000 average income / **$50,000 average investment).Average increase in income is [(50+40+30+20+10) / 5] = $30,000 per yearDepreciation is $100,000 / 5 years = $20,000 per year* Average income is $10,000 = (Average increase $30,000 – Depreciation $20,000)
** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]
The accounting rate of return criterion indicates both projects are equally attractive.
d. An advantage of the accounting rate of return is the incorporation of accounting income rather than cash flows for all periods. Disadvantages include not considering the time value of money and not explicitly considering the timing of cash flows.
e. Project B is recommended because it has the shorter payback period.
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LO486. a. ----1---- ----2---- ----3---- ----4---- ----5----
Present value of cash inflows at a 10% discount rate $56,727 $43,340 $33,614 $52,297 $37,976Initial investment (48,000 ) (36,000 ) (27,000 ) (45,000 ) (40,000 ) Net present value $ 8,727 $ 7,340 $ 6,614 $ 7,297 $ (2,024 )
b. Profitability index-------1------- -------2------- -------3------ -------4------- -------5-------
c. Only projects 1 through 4 are acceptable to Davidson Company. Project 5 is not acceptable because the project does meet the cost of capital requirement of 10%. This is pointed out with the negative net present value, the profitability index that is below 1, and the 8% internal rate of return.
d. 1. Net present value is unable to rank projects with different initial investments.2. Profitability ranking from highest to lowest is 3 2 1 4 53. Internal rate of return ranking from highest to lowest is 4 3 1 2 5
e. The profitability index indicates that Investment 3 is preferred, the internal rate of return indicates that Investment 4 is preferred, while the net present value method does not inherently distinguish between projects with different magnitudes of investment. However, because the profitability index is considered superior to the internal rate of return, I would recommend Investment 3. The final choice may depend on qualitative factors that distinguish the four alternatives.
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LO487. (Additional PV information is needed to complete this problem.) a. Payback period is 1.58 years = $244,000 amount invested .
$154,000 expected annual net cash inflow
b. Accounting rate of return is 1.05 = $128,000 average annual operating income from asset[($244,000 + 0) / 2] average amount invested in asset
c. Present value of annuity of equal net cash inflows for ten years assuming a 16% required rate of return $154,000 x 4.833 = ............$744,282Investment.....................................................(244,000 ) Net present value.......................................$500,282
d. $244,000 investment = 1.58 annuity present value factor$154,000 expected annual net cash inflow
A 1.58 annuity PV factor indicates an Internal rate of return of more than 50% for a ten-year investment.
e. Yes, a Papa John’s company-owned restaurant appears to be a good investment because the average payback period is less than two years, the average annual accounting rate of return is over 100%, the investment more than delivers the 16% required rate of return, and the internal rate of return is over 50%.
LO488. (Additional PV information is needed to complete this problem.)
a. The total initial investment, over the two years, is $24,000,000. The after-tax cash flows, as shown in the following exhibits are $4,100,000 per year. Therefore, the payback period, after the two-year initial investment period, is 5.85 years ($24,000,000/$4,100,000).
b. The initial investment is $24,000,000 and there is no salvage value. Therefore, the average investment is $12,000,000 ($24,000,000/2). The machine has a 12-year life, therefore the annual depreciation is $2,000,000. The annual taxes are $900,000 as showing in the following exhibits. Thus, the annual after-tax accounting income is $2,100,000 ($5,000,000 - $2,000,000 - $900,000). As a result, the accounting rate of return is 17.5% ($2,100,000/$12,000,000).
c. The net present value of this investment is ($252,737), as shown in the following exhibits.
d. The internal rate of return of this investment is approximately 11.8%, as shown in the following exhibits.
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EXHIBIT 1 Operating TaxablePeriod Investments Cash Flows Depreciation Income
LO189. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate
investments in long-term assets. Why do these assets deserve this attention?Solution: Long-term assets commit the organization to a technology or a process for long periods of time, creating a technological risk for the organization, and they can usually only be reversed at great cost. The investment in long-term assets is usually the largest that an organization makes, creating financial risk for the organization.
LO390. Some people believe that discounted cash flow analysis discriminates against long-term
projects because it heavily penalizes cash flows that occur well into the future. Comment.Solution: Discounted cash flow analysis penalizes cash flows that occur into the future to recognize the time value of money. For example, with a discount rate of 10%, a cash flow received 10 years from now is discounted to about 39% of its future value. This is a big penalty, however, it recognizes the time value of money and the real effect of investing in long-term assets.
LO491. Why might a company use a 10% discount rate to evaluate capital project ABC, and a
15% discount rate to evaluate capital project XYZ?Solution: The discount rate is adjusted for the level of risk involved with the project. The higher the discount rate used, the higher the level of risk for the project.
LO492. Explain the profitability index and the payback methods used in capital budgeting. Discuss
when it would be most appropriate to use each.Solution: The profitability index compares the present value of all future cash inflows with the present value of all future cash outflows. The discount rate allows for various amounts of risk. This is the most comprehensive capital budgeting analysis tool and it is used to evaluate the acceptability of a project and to rank projects.
The payback method uses the time to recover the initial investment as a measure of risk. It is easy to use but because this method does not utilize the time value of money, its use is usually limited to screening out unacceptable projects.
LO493. List two capital budgeting methods that utilize the time value of money and explain how
each ranks the performance of different alternatives.Solution: Two capital budgeting methods that utilize the time value of money are the net present value (NPV) method and the internal rate of return (IRR) method. The profitability index is used to rank the performance of capital projects evaluated using the NPV method. The IRR percentages can be used to rank the performance.
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LO494. Explain how the internal rate of return criterion, if improperly applied, can cause managers
to make inappropriate investment decisions.Solution: Suppose that an organization's cost of capital is 12% and that a decision maker has been told that she will be rewarded based on the return on investment of the assets under her control. The manager will be motivated to make return on investment as high as possible. Therefore, investments that provide a return on investment that is lower than the current average will be rejected, even though they may exceed the organization's cost of capital. The problem with return on investment is that it is improperly used for motivational purposes.
LO695. You are considering an investment in a new restaurant chain. You have developed
estimates of the initial investment required and the cash flows from that investment. However, you are wondering about the risk of your investment. How might you assess the impact of estimates in your investment decision?Solution: One approach is to use sensitivity analysis. In this approach, the investor would vary the cash flow estimates to identify how sensitive the decision to invest is to the estimated cash flows. If the decision is very sensitive, that is, a 5-10% decrease in cash flows would shift the investment decision from positive to negative, then the investor might want to take steps to improve the reliability of the forecasts or not invest in the project.
LO796. An organization is considering investing in an employee-training program. The
organization's planners expect that this training program, which would cost $5,000,000, will reduce manufacturing costs and increase the quality of the company's various products. How would you frame this decision in the capital budgeting context?Solution: If this project is to be evaluated using a capital budgeting tool, the organization will have to quantify the expected benefits of the training program. This may be difficult to do and, because of this, many organizations make investments like this as an act of faith that the benefits will exceed the costs.
LO897. An organization's planners have received a proposal from a manufacturing group to invest
in a new production line. The planners are suspicious that the proposal reflects the group's interest in acquiring the latest technology rather than reflecting sound economic evaluation. How might the planners deal with this situation?Solution: A common tool is to inform people proposing capital investments that the organization will perform post-implementation audits on all investment projects to identify whether benefits were as claimed and, if not, why not. Because this imposes risk on the people who propose projects, post-implementation audits dampen enthusiasm for all project proposals, not simply those that reflect non-economic considerations. Therefore, the organization must make it clear that the post-implementation audits will try to ensure that the audits are undertaken fairly with due consideration of events that would have been unforeseeable when the project was proposed.
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LO898. Officials at Dundas Manufacturing have just completed a post-implementation audit of a
distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group had proposed the warehouse investment arguing that it would improve sales by increasing product quality and improving customer service. The expected rate of return on this investment was 18%, however, the actual return on this investment to date has fallen far below this estimate and it is even below the company's cost of capital of 11%. The post-implementation audit concluded that the managers proposing this investment were ambitious, to the point of being reckless, in making the estimates underlying the project's proposals and argued that the investment should never have been made.
In response, the two managers who proposed the project argue that the proposal was a good one based on estimates that seemed sound at the time. However, several uncontrollable events, including the entry of a new competitor into the market, caused results to be lower than expected. Moreover, the two managers argue that results would have been even worse for the company if the investment had not been made. How would you deal with this situation?
Solution: This situation reflects the critical issue in interpreting a situation where events were not as expected. The argument hinges on two things. First, it is unreasonable to expect managers to be responsible for things beyond their control -- what is often called the controllability principle in management accounting. Second, the events that occurred in this situation were beyond the managers' control.
Many people believe that the controllability principle is fundamental because it appeals to a common sense of fairness, namely that people should only be held accountable for what they do or control. However, some people have argued that making people accountable for whatever happens motivates them to search for ways to gain control over their environment. Therefore, while rejecting the controllability principle at first seems harsh and conflicting with a common view of equity, there may be good behavioral reasons for doing this.
However, for the sake of discussion here, let us assume that the controllability principle is applied. There are two issues in this case: first, whether or not these managers should reasonably have anticipated the arrival of the new competitors and second, what would the results of the new competitor have been if the organization had not built the new warehouse. These issues are problematic and would have to be resolved by reference to the facts in the particular situation including what other competitors were doing, public announcements by the competitor, and what analysts who were following this market were writing and saying.
