CHAPTER 20 CAPITAL BUDGETING QUESTIONS 20-1 The three major steps in capital budgeting decisions are: project identification and definition, evaluation and selection, and monitoring and review. 20-2 Firms make capital investments to improve efficiency and productivity and to expand into new territories or products with the ultimate objective of earning a higher profit. This interest in profit is enhanced by the fact that all firms regularly compute and report periodic net incomes and that reported periodic incomes often play important roles in performance evaluations. As a result, many firms focus on effects that capital investments may have on the periodic net income that will be reported when they consider capital investments. Although net income is a measure on the outcome of a capital investment, overemphasizing the importance of net income can lead to erroneous capital investment decisions because of the requirement to conform with the generally accepted accounting principles when computing periodic net income which, among others, mandate the use of an accrual basis in all process. In contrast, capital investment decisions use cash flow data. The periodicity reporting requirement and the arbitrary process involved in determining net income lessen the usefulness of net income as an objective criterion. A net income is the result of applying accounting methods the firm chose to use. With a different, yet equally acceptable, accounting method the net income of a period can be substantially different. 20-3 Cash inflows: Fees from patients Proceeds from disposal of equipment no longer needed Solutions Manual
Transcript
CHAPTER 20 CAPITAL BUDGETING
QUESTIONS
20-1 The three major steps in capital budgeting decisions are: project identification and definition, evaluation and selection, and monitoring and review.
20-2 Firms make capital investments to improve efficiency and productivity and to expand into new territories or products with the ultimate objective of earning a higher profit. This interest in profit is enhanced by the fact that all firms regularly compute and report periodic net incomes and that reported periodic incomes often play important roles in performance evaluations. As a result, many firms focus on effects that capital investments may have on the periodic net income that will be reported when they consider capital investments.
Although net income is a measure on the outcome of a capital investment, overemphasizing the importance of net income can lead to erroneous capital investment decisions because of the requirement to conform with the generally accepted accounting principles when computing periodic net income which, among others, mandate the use of an accrual basis in all process. In contrast, capital investment decisions use cash flow data.
The periodicity reporting requirement and the arbitrary process involved in determining net income lessen the usefulness of net income as an objective criterion. A net income is the result of applying accounting methods the firm chose to use. With a different, yet equally acceptable, accounting method the net income of a period can be substantially different.
20-3 Cash inflows: Fees from patients Proceeds from disposal of equipment no longer needed Investment tax credits.
Cash outflows: Salary, wages, and benefits for additional professional medical staffs
including: Physicians Technicians Nurses Clerks
Operating expenses of the scanner such as: Utilities Supplies Maintenance expenses
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20-4 After 20 years of operation, a chemical company needs to ensure that there is no residual effect on the environment before abandoning the factory. Restoration of the site to remove any environmental effect to the neighborhood the factory might have caused over the years is the most critical step the firm needs to take. Very likely it is also among the most expensive processes.
20-5 Direct cash effects in capital budgeting are immediate effects that cash receipts, cash payments, or cash commitments have on cash flows of the firm. Direct cash effects in acquiring a new factory can include: acquisition or construction cost of the factory building, purchase costs for machinery and equipment needed for the factory, working capital for additional materials, payrolls, and operating expenses, cash receipts from selling the products, proceeds from sales of the old factory, machinery, and equipment replaced.
20-6 Tax effects are the effect that a decision or transaction has on the tax liability of the firm. Tax effects of a decision to acquire a new factory include: decreases in taxes because of the depreciation expenses of the new factory increases in tax payments for gains or decreases in tax payments for losses
on disposal of the replaced factory, machinery, or equipment or the abandonment of the investment at the end of its useful life
increases in tax payments for gains from operations or decreases in tax payments for losses on operations
investment tax credit
20-7 A book value by itself is irrelevant in capital budgeting since it has no effect on cash flow. However, a capital budgeting decision often involves disposal of one or more assets the firm no longer needs. Book values of the disposed assets are the bases in determining gains or losses on disposals. These gains or losses affect the tax payment of the firm, which, in turn, affect the cash flows of the firm.
20-8 Among the limitations of the payback period technique are its failure to consider an investment project’s total profitability and the time value of money.
The present value payback period technique considers the time value of money. It fails, however, to consider an investment project’s total profitability.
20-9 The book rate of return of an investment is not likely to yield a true measure of return on the investment because it does not consider the time value of money and includes in its computation measures that are results of the arbitrarily selected accounting procedures the firm chooses to follow.
The internal rate of return may not be a true measure of return on investment either, because it implies that all cash inflows from the investment have the same rate of return over the project’s entire useful years.
20-10 The decision criterion for the NPV method is the amount and direction of the net present value. A capital investment with a positive NPV is deemed a good investment. Furthermore, a higher NPV signals a better capital investment.
The IRR method uses a different decision criterion for evaluating capital investments. The decision criterion is the desired rate of return for the investment project. A project is a good investment if the rate of return on the project exceeds the desired rate of return. The desired rate of return can be the cost of capital of the firm, opportunity cost of the fund, hurdle rate the firm has for its investments, or a rate that the firm sets for the investment.
20-11 DCF techniques such as NPV or IRR assess impacts on cash flows of an investment. The focus of the technique is on cash flows and might leave out other important factors relevant to a capital investment such as effects of the investment on the firm’s strategic position, competitive advantage, community in which the firm locates or serves, or relationships with unions.
20-12 A sound capital investment decision needs to consider both quantitative and qualitative factors. Unfortunately, qualitative factors often are difficult or impossible to quantify. Decision-makers may leave out the impacts of non-quantitative factors in investment decisions because there are no numbers attached to these factors.
Among cost-benefit features that are often left out are effects on strategic position, competitive advantage of the firm, community, environment, and relationships with unions.
20-13 All investments require careful analyses and evaluations. Availability of funds for investment is but one factor in a capital investment decision. With unlimited funds available at 10 percent cost, the firm needs to ensure that its investment will earn a return on investments of at least 10 percent, the investment is part of the firm’s strategic plan, and that the firm has the requisite knowledge and time to manage the investment well.
With limited funds available for investment, the firm also needs to compare relative returns of competing investment opportunities, strategic direction of the firm, additional demands on management’s time, impacts on community, among others.
20-14 Among important behavioral factors that might affect capital investment decisions are: Desires of managers to grow through acquisitions and new investments. Tendency to escalate commitments Effects of prospects on capital investment decisions. Propensity of not wanting to spend additional time and effort needed to
secure capital investments. Intolerance of uncertainty.
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20-15 NPV method and IRR method may yield conflicting results when two investment projects differ in: size of initial investment timing of net cash inflows pattern of net cash inflow length of useful life
20-16 The size of initial investment has no effect on the rate of return as determined using the IRR method. A project with a larger initial investment, however, will most likely have a higher NPV than a project with a smaller initial investment and often becomes the preferred investment when using a NPV method to analyzing capital investments.
20-17 The net present value method weighs early net cash inflows heavier than late net cash inflows in at least two ways. First, amounts of discount applied to early net cash inflows are less than those of late net cash inflows. Thus, one dollar to be received in the first year increases the net present value of the investment project more than that of one dollar to be received in, say, the fifth years. Second, each dollar earns additional returns in each of the subsequent periods. Thus, an early dollar earns returns over a longer period of time than that of a late dollar.
20-18 Depreciation expenses affect capital investment decisions in two ways:1. Depreciation expenses decrease periodic net incomes from investment and,
thereby, reduce tax payments.2. Depreciation expenses decrease the book value of the investment and, as a
result, increase the gain or decrease the loss from the disposal of the investment which, in turn, affect the tax liability at the time the firm disposes of the investment.
20-19 The desired rate of return of a firm may change from one year to the next because of changes in, among others:1. investment opportunities available to the firm,2. bank or loan interest rates,3. market situation,4. priority of the firm.
20-20 a. The firm can expect to earn a higher return than the cost of funds needed for the investment if the internal rate of return is 11 percent and the cost of capital is 10%.
b. A capital project that has a net present value of $148,000 computed based on 10 percent discount rate indicates that the investment will earn the firm a return of $148,000 above the required 10 percent return on the investment.
20-21 A firm that chooses to build often faces many uncertainties, uses evolving technologies, and traverses in environments that are not familiar to management and can change rapidly. Capital budgeting processes in these firms are often less formal, rely less on formal analyses, use more nonfinancial and nonquantifiable data such as market share potential and competitors’ actions, and apply subjective criteria in evaluating capital investment projects. These firms are likely to require long payback periods or use a low hurdle rate.
In contrast, a firm that chooses to harvest is more likely to be in a mature market. As a result, its capital budgeting processes are more likely to be formalized. Most data needed for capital investment decisions are quantifiable and financial in nature. Its required payback period tends to be short and the hurdle rate high.
20-22 1. Capital budgeting is a process of assessing projects that require commitments of large sums of funds and generate benefits stretching well into the future. Among uses of capital budgeting are assessments of purchasing new equipment, acquiring new facilities, developing and introducing new products, and expanding into new sales territories.
2. Differences between payback and net present value methods of capital budgeting include recognition of time value of money, decision criterion for selecting the best investment, and number of periods considered. The payback method ignores the time value of money and treats one dollar today as the same as one dollar in the future. These two methods also differ in their decision criteria. Using the payback period method, a superior investment is the one with a short or quick payback. The decision criterion of the net present value method is the amount of net present values. A superior investment is the one with the highest net present value. In addition, the payback period method considers only cash flows needed to recover the initial investment. Cash flows after the payback period are not included in evaluations of capital investments when using a payback period method. In contrast, a net present value method includes all cash flows.
3. The cost of capital of a firm is the weighted average of the cost of the funds that comprise the firm’s capital structure.
4. Financial accounting data often are not suitable for use in capital budgeting because: a. financial accounting uses accrual accounting in all of its measurements.
The net income of a period may include revenues not yet paid by customers and exclude payments made to suppliers for future deliveries. Receivables included in the revenues of the period are not available to the firm for payments. The amount of cash paid is no longer available for other payments, even though the payment is not an expense of the period.
b. financial accounting data often are not suitable also because of the need to use arbitrary accounting procedures in financial accounting data.
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EXERCISES
20-23 EFFECTS ON CASH FLOWS (5 min)
a. $500,000 outflow at the time of payment. No effect on other
years.
b. Advertising expense: $50,000 x (1 - 20%) = $40,000
20-27 After-Tax Net Present Value And IRR (10 min)
a. 1. Net cash inflow each year: $62,000 - $30,000 = $32,000 Present value of net cash inflows = $32,000 x 3.17 = $101,440NPV = $101,440 - $60,000 = $41,440
2. Net cash inflow before depreciation $32,000Depreciation expense 15,000
Increase in net income before taxes $17,000Income taxes rate x 30%Income taxes $5,100
Net after-tax cash inflow = $32,000 - $5,100 = $26,900 per year
Present value of net cash inflows = $26,900 x 3.17 = $85,273NPV = $85,273 - $60,000 = $25,273
2. Assume that you have typed in the desired rate of return, 0.12, in a1, the required total initial investment, -500,000, in a2, and the periodic cash inflows, 120,000 in a3 through a12 and the cursor is at a15,
Microsoft Excel: For NPV:Insert Function Financial NPV
= NPV(a1, a2:a12) = $158,952 (Notice this answer is off by $19,075. This discrepancy can be avoided if you use the following function instead)
Or, Insert Function Financial PV
= PV(a1, 10, a3) = $678,027and then determining the NPV by subtracting the initial
investment from the output,$678,027 - $500,000 = $178,027
Or, Insert Function Financial NPV= NPV(a1, a3:a13) = $678,027 (with 0 in Cell a13)
For IRR: Insert Function Financial IRR= IRR(a2:a12) = 20%
Quattro Pro: For NPV:Insert Function Financial-Annuity @PV
@PV (a3, a1, 10) = $678,027Determine the NPV by subtracting the initial investment,
b. Average net income of the investment period: $812,000/10 = $81,200Book rate of return:a. On initial investment: $81,200/$500,000 = 16.24%b. On average investment:
Average investment: ($500,000 + 0)/2 = $250,000Book rate of return: $81,200/$250,000 = 32.48%
c. Net present value:
Year Net After-tax cash inflow
Discount Factor at 12%
Present Value of Net cash inflow
1 $50,000 0.893 $44,650
2 71,000 0.797 56,587
3 99,000 0.712 70,488
4 155,000 0.636 98,580
5 183,000 0.567 103,761
6 225,000 0.507 114,075
7 204,000 0.452 92,208
8 183,000 0.404 73,932
9 99,000 0.361 35,739
10 43,000 0.322 13,846
Total $703,866
NPV = $703,866 - $500,000 = $203,866
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20-29 (Continued-2)
d. Internal rate of return:
YearNet After-tax cash inflow
18% Discount Factor
PV of Net cash inflow at 18%
20% Discount Factor
PV of Net cash inflow
at 20%1
$50,000 0.847 $42,350 0.833 $41,6502
71,000 0.718 50,978 0.694 49,2743
99,000 0.609 60,291 0.579 57,3214
155,000 0.516 79,980 0.482 74,7105
183,000 0.437 79,971 0.402 73,5666
225,000 0.370 83,250 0.335 75,3757
204,000 0.314 64,056 0.279 56,9168
183,000 0.266 48,678 0.233 42,6399
99,000 0.225 22,275 0.194 19,20610
43,000 0.191 8,213 0.162 6,966Total
$540,042 $497,623
PV of net cash inflows at 18%: $540,042PV of net cash inflows at 20%: $497,623Difference in PV with 2% difference in discount rate $ 42,419
Taxes on the saving $16,000 x 40% tax rate = - 6,400
Net after Tax savings $9,600
2Years 1 and 2:
Book value at the time of overhaul: $10,000 x 2 + $20,000 = $ 40,000
Overhaul cost + 80,000
Total amount to be depreciated $120,000
Number of years 2
Depreciation expense per year $60,000
Tax Rate x 0.40
Tax savings on depreciation $24,000
Years 3, 4, and 5:
Overhaul cost $30,000
Number of years 3
Depreciation expense per year $10,000
Tax Rate x 0.40
Tax savings on depreciation $ 4,000
3. Although the cost difference between the two alternatives is only $2,834, which is less than 0.3% of the annual sales, the benefit from offering higher quality products two years earlier will most likely persuade the firm to undertake the overhaul two years early.
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20-36Comparison of Capital Budgeting Techniques (30 min)
1. Effects of the new equipment on net income: Sales $195 x 10,000 = $1,950,000
Depreciation on new equipment: ($995,000 - $195,000) / 4 = $200,000/year $200,000 / 10,000 units per year = + 20 + 45
Manufacturing cost per unit $135Number of units x 10,000
Total cost of goods sold - 1,350,000
Gross margin $ 600,000Marketing and other expenses:
Variable marketing: Cost per unit $ 10 Number of units x 10,000 $100,000 Additional fixed marketing cost + 200,000 300,000 Net income before taxes $300,000
Income taxes - 90,000 Net income $210,000
The firm will increase its net income by $210,000 each year.
2. Each of Year 1 to 3 Year 4
Net income after taxes $210,000 $210,000Add: Depreciation expenses included in fixed costs
$20 x 10,000 = 200,000 200,000Cash inflow from disposal of equipment 195,000 Total cash inflow $410,000 $605,000
The new machine will increase cash inflows by $410,000 in each of the first three years and $605,000 in Year 4.
4. Average investment = ($995,000 + $195,000)/2 = $595,000Average net income = $210,000Book rate of return = $210,000 / $595,000 = 35.29 percent
5. PV of net cash inflowsYear 1 through Year 3: $410,000 x 2.322 = $ 952,020Year 4: $605,000 x 0.592 = + 358,160
Total present value net cash inflows $1,310,180 Initial investment - 995,000
NPV $ 315,180
6. PV of cash flows at 25%:$410,000 x 1.952 + $605,000 x 0.410 $1,048,370
PV of cash flows at 30% $410,000 x 1.816 + $605,000 x 0.350 $ 956,310
Changes in PV of cash flows $ 92,060
7.a. The most decrease in after-tax net income per year withoutaffecting the decision $315,180 / 2.914 =$108,161Add: income taxes ($108,161 0.7) - $108,161 = + 46,354The most that variable cost per year can increase $154,515
Therefore, the variable cost per unit can increase by $154,515/10,000 = $15.45 per unit and the firm still will earn 14 percent on the investment.
b. The most that the unit selling price can decrease is $154,515 / 20,000 units = $7.73
20-37Replacing a Small Machine: Capital Budgeting Techniques and Sensitivity Analysis (20 min)
1. Although the new machine has the capacity of turning out 18,000 units per year, the analysis should be based on 10,000 units per year because there is no demand for the last 8,000 units at present time. This is a mistake that students often make.
Year 0 Purchase price of the new machine <$100,000> Proceeds from disposal $3,000 Taxes on gains on disposal < 600> 2,400 Cash outflow <$97,600>
Year 1-4Operating cost using the current machine ($40,000 + 10,000 + 10,000) x 0.8 = $48,000Operating cost using the SP1000
($30,000 + 2,000 + 1,000) x 0.8 = 26,400Savings in operating cost with the new machine $21,600Savings in taxes on depreciation expense
Depreciation expense $100,000 5 = $20,000Tax rate x 20% 4,000
Net cash inflows in each of Years 1-4 $25,600
Year 5After-tax cash inflow from savings in operating costs $25,600After-tax cash inflow from disposed of the investment
$5,000 x 0.8 = 4,000 Total cash inflow in year 5 $29,600
2. PV of cash inflow in each of years 1-4: $25,600 x 3.465 = $ 88,704PV of cash inflow in year 5: $29,600 x 0.747 = 22,111
Total PV of cash inflow $110,815 Less: Initial investment < 97,600> NPV $ 13,215
3. Payback period = $97,600 $25,600 = 3.81 years
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20-37 (Continued-1)4. The discount factor needed: $97,600 $25,000 = 3.904
Interest Rate PV of Net cash inflows 10% 10% $100,457 $100,457 ? 97,600 12% 94,954 2% ? $5,503 $2,857
6. Allowable after-tax increase in cost $13,215 4.212 = $3,1371 - tax rate 0.8Allowable cost increase before taxes $3,922Number of units 10,000Allowable cost increase per unit $0.3922
Indifference point: $3.30 + 0.3922 = $3.6922 per unit
The purchase of SP1000 will most likely be a right decision as long as the management is confident that the estimated new variable cost will be within 12 percent of the estimated amount ($0.3922/$3.30).
20-38Capital Budgeting with Sum-of-the-Years-Digit Depreciation (15 min)
20-44 Capital Budgeting with Sensitivity Analysis (15 min)
1. Expected annual net cash inflows ($600,000 + $100,000) $700,000Income taxes at 30% 210,000
After-tax net cash inflows $490,000
Let P denotes the maximum price the buyer would be willing to pay:P = $490,000 x A.12, 8 + (P/8 x 0.3) x A.12, 8
P = $490,000 x 4.968 + P/8 x 0.3 x 4.968P = $2,434,320 + 0.1863P
0.8137P = $2,434,320 P = $2,991,668
2. Let S denotes the minimum price Meidi can accept S = $460,000 x A.10, 8 + (S - 800,000 - 0.05S) x 0.4 + 0.05SS = $460,000 x 5.335 + 0.38S - 320,000 + 0.05SS = $2,454,100 + 0.43S - $320,000
0.57S = $2,134,100S = $3,744,035
3. Year Depreciation Tax Effect PV Factor Present Value 1 .2 P .06 P 0.893 .05358 P 2 .32 P .096 P 0.797 .076512 P 3 .192 P .0576 P 0.712 .0410112P 4 .1152P .03456P 0.636 .0219801P 5 .1152P .03456P 0.567 .0195955P 6 .0576P .01728P 0.507 .0087609P
.2214397PP = $2,434,320 + .2214397P
.7785603P = $2,434,320P = $3,126,694
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20-45Cash Flow Analysis and NPV (15 min) PV CASH FLOWS IN YEAR (in '000)
d. Investment in inventory and receivables < 600,000> <600> Recovery 0.519 311,400 600 e. Irrelevant f. Sales ($900 x 0.6) 3.433 1,853,820 540 540 540 540 540
g.Sales Promotion ($100 x 0.6) < 60,000> < 60>h.Termination ($50 x 0.6) 0.519 < 15,570> < 30> NPV $ 266,263
2. The positive net present value $266,263, suggests that, compared to the leasing alternative it is financially advantageous to convert the facility into a factory outlet. The net present value from converting into the factory outlet is also better then the alternative of selling the warehouse for $200,000.
20-46 Machine Replacement with Tax Considerations (15 min)
Present Value of Costs with the Original EquipmentPresent value of tax savings on depreciation: $2,500,000 4 x 0.45 x 2.577 = $724,781 Present value of operating costs: $1,800,000 x (1 - 0.45) x 2.577 = <2,551,230>Present value of salvage value:
$50,000 x (1 - 0.45) x 0.794 = 21,835 Present value of costs with the original equipment <$1,804,614>
Present value of the costs with the new machineInitial outlay
<$2,000,000>
Present value of tax savings on depreciation: Beginning Depreciation Tax Tax Discount Present
Year Book Value Expense Rate Saving Factor Value 1 $2,000,000 $1,333,333 x 0.45 = $600,000 x 0.926 = $ 555,600 2 666,667 444,445 x 0.45 = 200,000 x 0.857 = 171,400 3 222,223 222,223 x 0.45 = 100,000 x 0.794 = 79,400 Cash proceeds from sale of the old machine 300,000 Tax saving of loss on disposal of the old machine
($1,875,000 - $300,000) x 0.45 = 708,750Present value of operating costs
$1,000,000 x (1 - .45) x 2.577 = <1,417,350>Total cost at present value <$1,602,200>
Savings from using the new machine: $1,804,614 - $1,602,200 = $202,414
The total cost of the new machine, including the purchase cost and the operating cost in each of the three years, is $202,414 below the total cost of continuing with the original equipment. Financially purchase of the new machine is a good investment.
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20-47 Equipment Replacement (15 min)
1.a. Selling price $30.00Variables cost:
Direct materials $0.25 x 8 = $2.00Direct labor $8.00 x 2 = 16.00Indirect costs 0.30 18.30
f. Purchase price $100,000Proceeds from selling the old saw $4,000Tax savings from loss on disposal:
Book value $20,000Selling price 4,000Loss on sales $16,000Tax rate 0.40 6,400 10,400Net additional investment required $89,600
g. Increase in contribution margin per unit$19.60 - 11.70 = $ 7.90
Number of units x 100,000Increase in total contribution margin before taxes $790,000Increase in income taxes ($790,000 x 40%) - 316,000Increase in total contribution margin after taxes $474,000Additional tax savings from depreciation $7,000 x 0.4 = 2,800Expected additional net cash inflow per year $476,800
2. With over forty percent of the households in the community having at least one member working for the firm, the firm is a major employer of the community. Unless alternative employment opportunities can be created, a fifty percent reduction in its workforce will definitely have a major impact on the economy of the community.
To remain competitive the firm needs to upgrade its equipment. However, the shareholders and the management should not be the only beneficiaries from the additional net cash inflows. Although the firm may be able to ease the pain of layoffs by not filling positions vacated through retirement or resignation, a reduction of one-half of its employment will definitely be a major blow to the community. The firm needs to use the additional net cash inflows to create new job opportunities for the labor force to be reduced.
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20-48 Equipment Replacement with MACRS (15 min)
1. Contribution margins of the additional units:Sales price per unit $3,500Current manufacturing cost - 2,450Current contribution margin per unit $1,050Additional saving with the new machine + 150Contribution margin per unit of the additional units $1,200
Net cash inflows:Present Discount
Item Description Value Factor 2007 2008 2009 2010 Purchase cost <$608,000>Installation <12,000>Net proceeds from disposing old 30,000 Contribution margin
Per unit $1,200 $1,200 $1,200 $1,200Additional units 30 50 50 70CM from additional
units (‘000) $ 36 $ 60 $ 60 $ 84Efficiency saving (‘000) 125 125 125 125Total increase in CM
before taxes (‘000) $161 $185 $185 $209Income taxes (‘000) 64.4 74 74 83.6Total after tax increase
In CM before depreciation (‘000) $96.60 $111 $111 $125.4
After tax proceeds from disposal ($80,000 x .6) 48
Tax saving from depreciation (‘000) 81.84 111.60 37.20 17.36
Total net cash inflow 153,815 .862 $178.44 165,392 .743 222.60 94,996 .641 148.20 105,300 .552 190.76
Net Present Value <$70,497>
VacuTech can expect to have a negative net present value of $70,497 if it purchases the new pump.
2. Other factors the firm needs to consider include: Maintenance costs of the machines Reliability of the machines Changes and timing of newer machine Effects on production workers Learning effect on using the new machine Changes in market Competitors’ reaction
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20-49Joint Venture (5 min)
Present value of net cash inflows:
$900,000 x 0.8 x 4.192 = $3,018,240
Initial investment 3,000,000
NPV $ 18,240
Yes. The group can expect a positive NPV of $18,240.
3. Many firms raise discount rate in evaluating capital investments in view of uncertainties underlying the investment. This approach allows managers to factor in risks and uncertainties. The higher the risk or uncertainty a project has, the higher the discount rate.
However, managers should use a direct approach whenever possible in dealing with risk or uncertainty. For example, if a firm considers that revenues from an investment are likely to differ from the projected figures, the firm should adjust the projected revenues. If the expenses are likely to be higher, adjusting the projected expenses would allow the firm to be aware of the need for a higher amount of cash outflows. Using a direct approach whenever possible is better than simply using a higher discount rate.
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20-51Sensitivity Analysis (5 min)
1. 15 years: $600,000 x 6.142 = $3,685,200 Yes
12 years : $600,000 x 5.66 = $3,396,000 No
2. 600,000 x An, 14% = $3,500,000
Solving for An, 14% : An, 14% = 5.833
The discount factor at 14% for 13 years is 5.842
Therefore, the number of years needed for the Seattle facility to earn
