Chapter 9 Capital Budgeting Decisions QUESTIONS 1. A capital expenditure decision is a decision involving the acquisition of a long-lived asset. 2. Time value of money must be considered because the value of money received in the future from an investment is not equivalent to the value of money expended to acquire the investment in the current period. 3. Two approaches that consider the time value of money are the net present value (NPV) approach and the internal rate of return (IRR) approach. 4. With the net present value approach, investments are accepted if the net present value is equal to or greater than zero. With the internal rate of return approach, investments are accepted if the internal rate of return is equal to or greater than the required rate of return. 5. The cost of equity is the return demanded by shareholders for the risk they bear in supplying capital to the firm. 6. Because depreciation reduces taxable income, it results in a tax savings equal to the tax rate times the amount of depreciation. 7. The payback method does not consider the total stream of cash flows and it does not consider the time value of money. The accounting rate of return method does not consider the time value of money. 8. Managers may concentrate on short-run profitability rather than net present value if their performance is evaluated and compensated based on current period profit. 9. With uneven cash flows, the internal rate of return is calculated using a trial and error approach. Managers “guess” at the IRR and calculate the present value. If the present value is greater than zero, the guess is increased. If the present value is negative, the guess is decreased. 10. In many cases, the benefits of an investment are difficult to quantify (i.e., they are soft benefits). However, ignoring them is equivalent to ignoring cash inflows and tends to discourage investment.
Transcript
Chapter 9Capital Budgeting Decisions
QUESTIONS
1. A capital expenditure decision is a decision involving the acquisition of a long-lived asset.
2. Time value of money must be considered because the value of money received in the futurefrom an investment is not equivalent to the value of money expended to acquire theinvestment in the current period.
3. Two approaches that consider the time value of money are the net present value (NPV)approach and the internal rate of return (IRR) approach.
4. With the net present value approach, investments are accepted if the net present value isequal to or greater than zero. With the internal rate of return approach, investments areaccepted if the internal rate of return is equal to or greater than the required rate of return.
5. The cost of equity is the return demanded by shareholders for the risk they bear insupplying capital to the firm.
6. Because depreciation reduces taxable income, it results in a tax savings equal to the tax ratetimes the amount of depreciation.
7. The payback method does not consider the total stream of cash flows and it does notconsider the time value of money. The accounting rate of return method does not considerthe time value of money.
8. Managers may concentrate on short-run profitability rather than net present value if theirperformance is evaluated and compensated based on current period profit.
9. With uneven cash flows, the internal rate of return is calculated using a trial and errorapproach. Managers “guess” at the IRR and calculate the present value. If the presentvalue is greater than zero, the guess is increased. If the present value is negative, the guessis decreased.
10. In many cases, the benefits of an investment are difficult to quantify (i.e., they are softbenefits). However, ignoring them is equivalent to ignoring cash inflows and tends todiscourage investment.
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EXERCISES
E1. Interest expense is not treated as a cash outflow because the “charge” forinterest is included in the cost of capital (i.e., the hurdle or discount rate).
E2. The NPV is positive and Pauline should make the investment.
Although the project has a positive NPV, if Pauline is overly focused onshort-term performance, she may hesitate to make the investment, whichhas a relatively low ROI in the first year. Note that ROI increasesdramatically as the book value of the investment decreases due todepreciation.
Chapter 9 Capital Budgeting Decisions 9-3
E3. According to Mignogna,
“You can often determine the cash benefit of increases in capacity,production efficiency, and quality, as well as reductions in operating and
maintenance costs attributable to an investment in new technology.
However, seldom accounted for are the strategic benefits which result fromsuch investments. With the assistance of the accompanying decision-
making flow chart, let’s look at a few.
First of all, is the investment required just to stay in game (for example,
required for regulatory compliance)? If so, and assuming the game is worthbeing in, then you may not have any choice but to “just do it!”
Next, have you considered the importance of the investment to remain
competitive in your industry? Here, I am speaking of your ability to
acquire, or at least defend, market share. While discounted cash flowanalyses may include the benefits of reduced operating costs and so on,
they seldom consider the opportunity cost of the lost business which
results from your competitors’ ability to offer a higher quality at a reducedcost. In other words, there may be a very real cost attached to not pursuing
an innovation.
There are several other strategic considerations that are not particularly
amenable to economic analyses. Will the investment add to or enhanceyour firm’s core competencies? Will it provide the capability to penetrate
new markets with your product or service? Will expanded productioncapacity provide access to increased sales and more rapid learning curve
progress which will ultimately lower costs? Are you in an industry where
the market perceives technological leadership as important? You canprobably think of others specific to your own situation. Such strategic
benefits are seldom considered in discounted cash flow analyses of newtechnology. Remember, there’s a big difference between running the
numbers and letting the numbers run you.”
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E4. Company Investment decisionCharles Schwab Should the company purchase additional servers and other
equipment to enhance services related to the onlinebusiness?
McDonalds Should the company purchase land, building, and
equipment for a new restaurant?Wal-Mart Should the company remodel it’s superstore on the west
E12. Machine A should be purchased because it has the highest positive NPV.
Machine ACash Present ValueFlow Factor Total
$15,000.00 4.3553 $65,329.50
(50,000.00) 1.0000 (50,000.00)$15,329.50
Machine BCash Present ValueFlow Factor Total
$20,000.00 4.3553 $87,106.00
(75,000.00) 1.0000 (75,000.00)$12,106.00
Chapter 9 Capital Budgeting Decisions 9-7
E13. The investment should not be undertaken because the internal rate of returnof 12% is less than the required rate of 18%.
Initial outlay $79,100.00
Annuity amount 14,000.00
Outlay ÷ annuity amount 5.6500
Internal rate of return 12%
E14. a.Initial outlay $79,137.00
Annuity amount 22,500.00
Outlay ÷ annuity amount 3.5172
Internal rate of return 13%
b. Nadine should make the investment because its return of 13% is greater
than the required return of 12%.
E15. Annual depreciation
$200,000 ÷ 5 years $40,000.00
Annual tax savings $40,000 × .40 $16,000.00
Present value of $16,000 per year
for 5 years at 10% $16,000 × 3.7908 $60,652.80
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E16. Year Income (Loss)1 ($100,000)
2 (50,000)3 120,000
4 200,000
The $100,000 loss in year 1 will offset income in year 3 resulting in a taxsavings of $40,000 (i.e., $100,000 × 40% tax rate) in year 3.
With respect to the $50,000 loss in year 2, $20,000 of it can be used to offset
income in year 3 (resulting in a tax savings of $8,000 in year 3) and $30,000of it can be used to offset income in year 4 (resulting in a tax savings of
Average income $30,000.00Average investment ($200,000 ÷ 2) 100,000.00
Accounting rate of return 30.00%
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E20. As indicated, the NPV is close to zero ($145.00) at a rate of 14%. Thus, theIRR is approximately 14%. Given that the required rate of return is only
E21. As indicated below, the NPV is zero with a required rate of return of 9percent. Thus, the IRR is 9 percent.
PV at Cash PV9% Flow Factor Total
$(2,200,100) 1.0000 $(2,200,100)
200,000 0.9174 183,480400,000 0.8417 336,680
600,000 0.7722 463,320
800,000 0.7084 566,7201,000,000 0.6499 649,900
$ 0
E22. The online business may help the company manage a potentially stodgyimage associated with its mall locations. Also, the online business may
actually generate a number of large sales for the brick and mortar locations.Some customers will shop the Web site to make price and quality
comparisons, but they will be unwilling to make, for example, a $5,000
purchase of a diamond ring over the Internet. Thus, after seeingmerchandise on the Web site, they may visit one of Sherman’s mall stores to
make a purchase. These potential benefits would be difficult to quantify.
E23. The annual value of the “soft” benefit must be at least $88,492.44 for theproject to have a zero net present value. Given there is general agreement
that the annual “soft” benefit will be at least $90,000, Pritchard should investin the flexible manufacturing system.
A. Present value needed to yield a zero NPV $500,000.00
B. Present value of an annuity factor at 12% 5.6502
A ÷ B Required annual value of “soft benefit” $88,492.44
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PROBLEMS
P1. The original contract was worth $6,790,700 in present value terms while thenew offer is worth $6,960,460. When the time value of money is taken into
account, it is obvious that the new offer is not much better than the old one.
P2. a. Present value of ship in Caribbean/Alaska itinerary at 10%($68,095,769 × 7.6061) $517,943,229
Present value of ship in Caribbean/Eastern Canada itinerary at 10%
($53,490,300 × 7.6061) $406,852,571
Present value of ship in Caribbean/Alaska itinerary at 15%
($68,095,769 × 5.8474) $398,183,200
Present value of ship in Caribbean/Eastern Canada itinerary at 15%($53,490,300 × 5.8474) $312,779,180
The cost of the ship is only $180,325,005. Therefore, the NPV will be positiveunder all of the alternatives which provides strong evidence that the ship
should be purchased.
b. The NPV will be positive (suggesting that the ship should be purchased)whether the required return is 10 percent or 15 percent.
c. The difference in present values is $111,090,658 ($517,943,229 -
$406,852,571). Thus, there is a high opportunity cost if the firm decides tooperate the ship in a Caribbean/Eastern Canada itinerary.
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P3. Year 1 Year 2 Year 3 Year 4Revenue $12,000,000 $6,000,000 $2,000,000 $500,000
Less amortization 12,000,000 4,000,000 0 0Income before taxes 0 2,000,000 2,000,000 500,000
Less taxes 0 800,000 800,000 200,000
Net income 0 1,200,000 1,200,000 300,000Add amortization 12,000,000 4,000,000 0 0
Given the positive NPV, the company should invest in the new business.
Chapter 9 Capital Budgeting Decisions 9-21
P11. a. The cost of capital includes an allowance for expected inflation. Thus, inperiods where expected inflation is high, the cost of capital is high, and
firms demand a high return on their investments.
b. Note that cash flows increase by 4% per year (except for the cash flowrelated to the depreciation tax shield).
Year Cash flow Factor Total1 $513,750 .9091 $ 467,050
2 528,700 .8264 436,918
3 544,248 .7513 408,8944 560,418 .6830 382,765
5 577,235 .6209 358,4052,054,032
Less cost of machine 2,000,000
Net present value $ 54,032
Given the positive NPV, the company should invest in the manufacturing
equipment.
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P12. Note that in problem 11, the NPV was only $54,032 using a 10% requiredrate of return. This suggests that to determine the IRR, we should start with
a return larger than, but close to, 10 percent. Below, the cash flows arebrought to present value using an 11% rate of return. Since the sum of the
present values is approximately equal to the cost of the investment (a
difference of $1,620), the internal rate of return is approximately 11%.Given that this is greater than the required return of 10%, the investment
should be undertaken.
Year Cash flow Factor Total1. $513,750 .9009 $ 462,837
2. 528,700 .8116 429,0933. 544,248 .7312 397,954
4. 560,418 .6587 369,147
5. 577,235 .5935 342,5892,001,620
Less cost of machine 2,000,000Net present value $ 1,620
Chapter 9 Capital Budgeting Decisions 9-23
P13. Most likely, a higher required rate of return should be used reflecting theincreased risk of the investment.
P14. a. Richards is evaluated and compensated based on ROI which has some
measure of income in the numerator (and a measure of investment in the
denominator). Thus, he will be highly focused on income. Someinvestment opportunities facing his division may increase shareholder
wealth (as indicated by positive NPVs) but have a negative effect onshort-run accounting income. If that will cause Richards to miss a bonus
target, he may pass on these valuable investments.
b. I believe this will mitigate the problem. If Richards owns a great deal ofstock/and or options, he will have a strong incentive to work to increase
the firm’s stock price. And stock prices are likely to be positively
impacted when the firm takes on projects with positive NPVs.
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P15. Year 1 Year 2 Year 3 Year 4 Year 5Revenue $63,000 $69,300 $76,230 $83,853 $92,238
