Chapter 26

CHAPTER 26
CAPITAL BUDGETING
15th edition
Brief Learning
Exercises Topic Objectives Skills
B. Ex. 26.1 Understanding payback period 3 Analysis
B. Ex. 26.2 Use of return on investment 3 Analysis
B. Ex. 26.3 Comparing NPV and required rate of return 3, 4 Analysis
B. Ex. 26.4 Net present value computations 3 Analysis
B. Ex. 26.5 Computations for payback period 3 Analysis
B. Ex. 26.6 Capital investment challenges 1, 2 Analysis, judgment
B. Ex. 26.7 Net present value and required rate of return 3, 4 Analysis, judgment
B. Ex. 26.8 Capital budgeting behaviors 5 Analysis, judgment
B. Ex. 26.9 Net present value analysis 3 Analysis
B. Ex. 26.10 Nonfinancial investment concerns 2 Analysis, communication,
judgment
Learning
26.1 Accounting terminology 15 Analysis
26.2 Payback period 13 Analysis, communication,
judgment
26.3 Understanding return on average investment 1, 3 Analysis
26.4 Discounting cash flows 3 Analysis
26.5 Understanding net present value
relationships
3 Analysis
26.6 Analyzing a capital investment proposal 1, 3 Analysis
26.7 Analyzing capital investment proposal 14 Analysis, communication,
judgment
26.8 Analyzing capital investment proposal 1, 3 Analysis
26.9 Competing investment proposals 1, 2, 5 Analysis, communication,
judgment
26.10 Replacing existing equipment 13, 5 Analysis, communication,
judgment
26.11 Gains and losses on sale of equipment 3 Analysis
26.12 Depreciation effects on cash flows 3 Analysis
OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL
THINKING CASES
The McGraw-Hill Companies, Inc., 2010
CH26-Overview
Learning
26.13 Net present value in a not-for-profit 2, 3 Analysis, communication,
judgment
26.14 NPV of uneven cash flows 3 Analysis
26.15 Real World: Home Depots present value of
store closing costs
13 Analysis, communication,
judgment , research
Problems Learning
Sets A, B Topic Objectives Skills
26.1 A,B Capital budgeting and determination of
annual net cash flow
14 Analysis
26.2 A,B Analyzing capital investment proposals 14 Analysis, judgment,
communication
26.3 A,B Analyzing capital investment proposals 14 Analysis, judgment,
communication
26.4 A,B Capital budgeting using multiple models 14 Analysis, judgment,
communication
26.5 A,B Capital budgeting using multiple models 14 Analysis, communication,
judgment
26.6 A,B Analyzing a capital investment proposal 3 Analysis
26.7 A,B Considering financial and nonfinancial
factors
judgment
26.8 A,B Analyzing competing capital investment
proposals
judgment
26.9 A,B Analyzing competing capital investment
proposals
judgment
Critical Thinking Cases
26.1 How much is that laser in the window? 24 Analysis, communication,
judgment
26.2 Dollars and cents versus a sense of ethics 15 Analysis, communication,
research
26.3 International investments in outsourcing 1, 2, 5 Analysis, communication,
(Business Week) judgment
26.4 Real World: Sears 1, 2, 5 Analysis, communication
Capital investment history judgment, research,
(Internet) technology
26.5 Real World: Red Robin Gourmet 5 Analysis, communication
Burgers judgment
(Ethics, fraud and corporate governance)
CH26-Overview (p.2)
DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES
Problems (Sets A and B)
26.1 A,B Toying with Nature/Monster Toys 30 Strong
Covers incremental analysis and three basic capital budgeting
techniques in a single problem.
26.2 A,B Micro Technology/Macro Technology 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.3 A,B Banner Equipment Co./Flagg Equipment Co. 25 Medium
26.4 A,B Marengo/Tango 25 Medium
26.5 A,B V.S. Yogurt/I.C. Cream 25 Medium
26.6 A,B Rothmore Appliance Company/Cafield Appliance Company 30 Strong
Prepare a schedule showing the estimated incremental net income from
proposed introduction of a new product. Compute annual cash flow,
payback period, return on average investment, and net present value of
the investment proposal.
26.7 A,B Doctors 40 Strong
Students must determine whether it is profitable for several doctors to
invest their money in an expensive piece of testing equipment. Requires
financial analysis and consideration of nonfinancial aspects of their
decision.
Below are brief descriptions of each problem and case. These descriptions are accompanied by the
estimated time (in minutes) required for completion and by a difficulty rating. The time estimates
assume use of the partially filled-in working papers.
Description of Problems
26.8 A,B Jefferson Mountain/Madison Mountain 50 Strong
A small ski resort must decide between alternative investment
proposals. Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
26.9 A,B Sonic, Inc./Boom, Inc. 45 Strong
A software company is trying to decide how to market their software.
Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
Desc. of Problems (p.2)
Critical Thinking Cases
26.1 The Case of the Costly Laser 25
Compute the net present value of a proposal to replace existing
equipment with new, more efficient equipment. The sale of the existing
equipment will involve a large loss. Students are asked to comment on
the relevance of this sunk cost.
26.2 Grizzly Community Hospital 60
A small community hospital considers a major capital investment in a
regional kidney center. Students are asked to analyze financial and
nonfinancial information relevant to the decision, explore alternative
uses of resources, and help the hospital define its role.
26.3 International Investments in Outsourcing 20
Business Week
The cash flows associated with offshore investments are identified.
Ethical considerations of asking domestic employees to train their
international replacements are considered.
26.4 Sears, Roebuck and Company 25
Internet
This assignment requires students to review a short history of Sears and
identify major capital investment decisions made by the company since
its inception in the late 1800s. For one such decision, nonfinancial
considerations are to be discussed.
26.5 Goverance and Capital Budgeting Conflicts 30
Ethics, Fraud & Corporate Governance
Governance violations at Red Robin Gourmet Burgers leads to capital
budgeting conflicts of interest.
Desc. of Cases
Strong
Strong
Medium
Easy
Medium
Desc. of Cases
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1.
2.
3.
4.
5.
6.
7.
8.
In appraising the adequacy of a rate of return, an investor should consider the cost of investment
capital, the rates of return available on alternative investment opportunities, the risk associated
with realizing the estimated rates of return, and the nonfinancial aspects of this and other
investment opportunities.
Capital budgeting is the process of planning and evaluating investments in plant assets. Capital
budgeting decisions are crucial to the long-run financial health of a business enterprise because
large amounts of funds are committed for long periods of time. Also, capital budgeting decisions
often are difficult to reverse once the funds have been committed.
Corporate management would allow a lower rate of return for newly developing divisions, when
there is a strategic necessity to penetrate a new market, or when acquiring a new technology
where cash flow estimation is extremely difficult.
The major shortcoming in using the payback period as the sole criterion in capital budgeting
decisions is that this method ignores the total life and, therefore, the total profitability and total
cash flow to be derived from the investment.
The present value of a future amount is the amount of money which, if invested today to earn a
return equal to the discount rate, would become equivalent to the future amount at the future
date. Less money needs to be invested to grow to a specified amount if that investment will earn
a 15% return than if it will earn only 10%.
The present value of a future cash flow is dependent upon (1) the amount of the future cash flow,
(2) the length of time until that cash flow will occur, and (3) the discount rate used to reduce the
future cash flow to its present value.
Discounting cash flows takes into consideration the timing of the earnings stream. The return on
average investment is based upon average annual earnings and, therefore, does not distinguish
between income received early or late in the life of the investment. Discounting cash flows
recognizes the time value of moneythe economic fact that receiving a given cash flow in the
near future is preferable to receiving the same cash flow in the more distant future.
Nonfinancial considerations associated with the installation of a fire sprinkler system may
include (1) an ethical responsibility to provide safe working conditions, (2) compliance with
federal and/or state safety standards, and (3) reducing the risk of having inventory destroyed by
fire.
Q1-8
9.
10.
11.
12.
13.
14. Although depreciation expense does not require a payment in cash, it is an important
consideration in the discounting of an investments future cash flows because of its income
tax consequences.
Timing differences are very important in present value computations and projects that have
more significant cash inflows after several years will inevitably have lower present values
than projects with significant cash inflows in the immediate years after the investment has
been made. To consider this difference, consider making an investment in an existing
McDonalds that is well established with a current stream of positive net cash flows. Now
consider starting a new business with a franchise that is not as well known. The new business
will require construction before it even opens, delaying cash flows. Even after it is open it will
take significant time to build up a steady clientele. These differences in timing of cash flows
can make purchasing an existing business with a strong brand a more attractive (and as a result
a more expensive) alternative.
If an investment with no salvage value has a payback period that exceeds its estimated life, the
investments net present value will be negative. If the payback period exceeds the assets life,
the total cash flows generated by the investment will be less than the initial cost of the
investment. Thus, the discounted present value of those cash flows must also be less than the
initial cost of the investment, making its net present value negative.
If an investment proposal has a net present value of zero, the expected rate of return is equal to
the discount rate.
Factors to consider in establishing a minimum required return on an investment proposal may
include (1) the companys cost of capital, (2) the relative risk of the investment, (3) returns
associated with alternative investment proposals, (4) the expected life of the investment, (5)
the investments impact on keeping the company competitive, (6) how quickly the technology
associated with the investment is changing, and (7) nonfinancial considerations such as ethical
and legal issues.
An investments contribution to income is not the same as its incremental cash flow because
income is not defined as net cash flow. In an accrual-based accounting system, revenues are
recognized when earned, not when cash is received. In addition, expenses are recognized when
incurred, not when cash is disbursed.
Q9-14
15.
16.
17.
18.
19.
20.
One way to ensure that employee estimates of the costs and benefits of capital investments are
not overly optimistic or pessimistic is to implement a system for auditing capital budget
decisions. With an audit system in place, employees will be aware that their estimates will be
checked against actual results, and any biases discovered. Another step firms can take is to use
routing forms, where several high-level managers must sign off on a capital expenditure. Each
manager then has the opportunity to question or verify the estimates. Employees will be less
likely to bias estimates if they know they will be scrutinized by several managers. Finally, a
firm may employ a neutral third party to provide a second set of estimates. If there are large
discrepancies between the two estimates, further investigation can be undertaken.
If a company is replacing an asset, the first income tax consequence to be considered is
whether the old asset will be sold at a gain or a loss (a loss is most likely). A loss can be
immediately deducted on the tax return instead of deducting it over the remaining life of the
asset. Income taxes will also be affected by a difference in operating expenses and deductions
for depreciation due to the new asset.
A manager prefers the investment opportunity that has the lowest risk, the shortest payback
period, and the highest rate of return.
The discount rate is equivalent to the rate of return required by an investor. This is important
because an investor wants a project to cost less than the present value of its future cash flows.
In order for this to be accomplished, the expected rate of return exceeds the required rate of
return.
Some capital investment proposals which may favor nonfinancial factors include a pollution
control systems, new factory lighting, an employee health club, and an employee child care
facility. When deciding whether to undertake any of these projects, many nonfinancial
considerations come into play such as environmental concern, employee morale, flexibility,
better working conditions, etc.
Employees are going to be affected by any capital budgeting decisions a firm makes.
Therefore, employees who make estimates regarding proposals may inflate or deflate
estimates based on how the investment would affect the employee. Also, estimates come from
a variety of sources and there is always possibility of error.
Q15-20
B. Ex. 26.1 The payback period is computed as follows:
Amount Invested
Annual Net Cash Flow
B. Ex. 26.2 Proposal 1:
Average investment = (Original cost + salvage value) 2
($115,000 + $11,000) 2 = $63,000
ROI = (Average estimated net income average investment)
$13,000 $63,000 = 20.6%
Proposal 2:
Average investment = (Original cost + salvage value) 2
($93,000 + $5,000) 2 = $49,000
ROI = (Average estimated net income average investment)
$10,500 $49,000 = 21.4%
B. Ex. 26.3
B. Ex. 26.4 Present value of expected annual cash flows ($19,000 4.111) 78,109 $
Present value of proceeds from disposal ($2,000 .507) 1,014
Total present value of investments future cash flows 79,123
Cost of investment (56,000)
Net present value of proposed investment 23,123 $
B. Ex. 26.5 Amount to be invested $45,650
Est. annual net cash flows $11,000
B. Ex. 26.6
$100,000
$10,000 + $5,000
SOLUTIONS TO BRIEF EXERCISES
= = 4.15 years
Replacement equipment is typically among the easiest for which to estimate cash
flows primarily because the company has experience with similar types of
equipment. Thus, replacing a fleet of trucks, where 20% of the fleet is replaced
each year so that over a five year period all trucks have been replaced, is the type
of investment that is easy to estimate cash flows.
= =
or 6 years 8 months.
6 2/3 years
If the investment proposal has a positive net present value of $20 when an 8%
discount rate is used, its actual rate of return must be slightly above 8%. Because
its net present value is a negative $2,000 when a 10% discount rate is used, we
may conclude that the investments actual rate of return is less than 10%, and
very close to 8%.
BE26.1,2,3,4,5,6
B. Ex. 26.7
B. Ex. 26.8
B. Ex. 26.9 Present value of expected annual cash savings ( X 3.791) . = ???
Present value of proceeds from disposal ($150,000 .621) = 93,150 $
Total Present Value of investments future cash flows.. 350,000 $
Cost of investment 350,000 $
Net present value of proposed investment 0
Thus, the expected annual cash savings:
X = ($350,000 - $93,150) 3.791 = $67,753
B. Ex. 26.10
If the initial outlay for the project is $125,000 and the net present value of the
future cash flows is $120,000, then the present value (based on the 12% required
rate of return) of the salvage value must be equal to at least $5,000. The salvage
value is $10,000 in 10 years. The discount rate from the table is .322. Thus the
present value of $10,000 at 12% over 10 years is $3,220. This is below the $5,000
needed to have a net present value of 0 for the project. Thus the projects rate of
return must be below 12%.
The net present value cash flows could be optimistic because the outside sales
person was optimistic about the value added of the new equipment and Ron was
optimistic about the new equipment. Ron obviously likes more satisfied
employees. However, how that satisfaction can be translated into higher cash
flows is uncertain.
Sams should also consider the potential cannibalization of in-store sales, the
possible additional advertising that is available from on-line activities, the
potential to reach a national customer base, the need for distribution services,
the need for return services, quality issues when shipping is not under Sam's
control, etc. Students will have many answers.
Alternatively, new technology is inherently difficult to estimate. For example,
when VCRs, DVD players, or I-Pods were first introduced to the market, the
prices were set fairly high because manufacturers could not estimate demand. As
demand grew and as the company moved further down its learning curve and
achieved economies of scale, then prices fell. Estimating demand for new
technologies and products is extremely difficult. The net present value of
investment in R&D is very difficult to estimate. The nonfinancial characteristics
that differ are mostly about uncertainty.
BE26.7,8,9,10
BE26.7,8,9,10
SOLUTIONS TO EXERCISES
Ex. 26.1 a.
b.
c.
d.
e.
f.
g.
h.
i.
Ex. 26.2 a.
$27,000
$6,000*
b.
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
c. Based strictly on payback periods, the Toledo Tools machine is more attractive
because its cost will be recovered one year sooner than the cost of the Akron
Industries machine. However, the payback period should never be the only
factor used to evaluate an investment decision because it ignores the
profitability of an investment over its total life, it ignores the discounted
present values of the investments future cash flows, and it ignores important
nonfinancial considerations.
If the Akron Industries machine has a payback period of 66 months (or 5.5
years), its cost can be computed as follows:
= 5.5 years
$26,000 - $20,000 = $6,000
27,000 - 21,000 = 6,000
32,000 - 26,000 = 6,000
35,000 - 29,000 = 6,000
34,000 - 28,000 = 6,000
Incremental analysis
Sunk cost
Capital budgeting
Return on average investment
Salvage value
The payback period for the Toledo Tools machine is computed as follows:
Estimated Annual Net Cash $6,000*
Payback period
None (This statement describes the amount to be subtracted from an assets
initial cost in determining its net present value.)
Present value
Discount rate
Amount to Be Invested
= = 4.5 years
Estimated Annual Net Cash
33,000 - 27,000 = 6,000
Cost = $6,000 5.5 years = $33,000
*The estimated annual net cash flow of both investments:
=
Cost
E26.1,2
Ex. 26.3
Original Cost + Salvage
Value
2
Average Investment =
= 20%
Average Investment = $3,400 20% = $17,000
Thus, the estimated salvage value of I nvestment C is:
= $25,000
= 25%
$6,000
$24,000
I nvestment B
Thus, the average estimated net income of I nvestment B is:
=
Average Investment
Salvage Value = ($17,000 2) - $25,000 = $9,000
$25,000 + $ ?
2
Average Estimated Net Income = 32% $25,000 = $8,000
I nvestment C
The average investment of I nvestment C is:
Average Estimated Net Income
=
3400
Average Investment $ ?
$25,000
= 32%
=
$45,000 + $5,000
2
Average Investment
$ ?
Value
2
The missing data for each investment proposal are solved for as follows:
I nvestment A
Value
2
(Continued on the following page)
Thus, the return on average investment of I nvestment A is:
= = $24,000 Average Investment
$40,000 + $8,000
2
E26.3
Ex. 26.4 a.
b.
c.
d.
Ex. 26.5
(Continued on the following page)
I nvestment A
$10,000 .061 = $610
$15,000 5.019 = $75,285
($10,000 3.352) + ($12,000 .497) = $33,520 + $5,964 = $39,484
There are several ways to approach this problem. Shown below is the present value
of $20,000 received annually for 5 years plus the present value of the additional
$10,000 received annually for the first 3 years:
Net present value (given as zero) ..
Thus, original cost of I nvestment A is: ..
Present value of annual net cash flows discounted at 12% for 10 years
($35,000 - $ ?) 5.650 (from Exhibit 26.4) .
($16,000 - $6,000) 6.145 (from Exhibit 26.4) ..
Less: Investment cost .
=
2
Thus, the original investment cost of I nvestment D is:
Original Cost + Salvage Value
I nvestment B
= $20,000
The missing information for each investment is solved for as follows:
Less: Investment cost
Net present value (given as zero) .
Average Investment
Salvage Value = ($20,000 2) - $4,000 = $36,000
Average Investment
($20,000 3.352) + ($10,000 2.283) = $67,040 + $22,830 = $89,870
Alternatively, the student could determine the present value of $30,000 received
annually for 3 years ($68,490) and then add the present value of $20,000 received at
the end of the fourth year ($11,440) and the present value of another $20,000
received at the end of the fifth year ($9,940).
2
=
$ ? + $4,000
I nvestment D
The average investment of I nvestment D is:
=
$ ?
= 15%
Average Investment
$3,000
E26.4,5
$ 61,450
?
$ 0
$ 61,450
$ ?
141,250
$ 0
$10,000 .061 = $610
$15,000 5.019 = $75,285
($10,000 3.352) + ($12,000 .497) = $33,520 + $5,964 = $39,484
There are several ways to approach this problem. Shown below is the present value
of $20,000 received annually for 5 years plus the present value of the additional
$10,000 received annually for the first 3 years:
Thus, the original investment cost of I nvestment D is:
The missing information for each investment is solved for as follows:
Salvage Value = ($20,000 2) - $4,000 = $36,000
($20,000 3.352) + ($10,000 2.283) = $67,040 + $22,830 = $89,870
Alternatively, the student could determine the present value of $30,000 received
annually for 3 years ($68,490) and then add the present value of $20,000 received at
the end of the fourth year ($11,440) and the present value of another $20,000
received at the end of the fifth year ($9,940).
I nvestment D
The average investment of I nvestment D is:
E26.4,5
Ex. 26.6 $300,000
$325,000 - $225,000
b.
$25,000
$300,000 2
c.
=
Less: Amount to be invested
Net present value of proposal ..
Net present value of proposal, discounted at an annual rate of 12%:
Total present value of annual net cash flows
($325,000 - $225,000) 3.037 ..
Average Investment
= = 16.7%
Return on average investment:
Average Net Income
Given a net present value of zero, we can conclude that the discounted present value of the future
cash flows associated with I nvestment B must equal the investments original cost of $141,250.
Present value of annual net cash flows discounted at ?% for 10 years
($19,000 - $7,000) ?%
Less: Investment cost .
I nvestment C
Thus, the annual cash outflows associated with the investment can be computed as follows:
($35,000 - Cash Outflows) 5.650 = $141,250
($35,000 5.650) - (5.650 Cash Outflows) = $141,250
cash flows associated with I nvestment C must equal the investments original cost of $88,320.
Thus, the discount rate associated with the investment that yields a net present value of zero can
be computed as follows:
Net present value (given as zero)
($19,000 - $7,000) PV Factor = $88,320
$12,000 PV Factor = $88,320
$197,750 - (5.650 Cash Outflows) = $141,250
Cash Outflows = $56,500 5.650 = $10,000
$197,750 - $141,250 = (5.650 Cash Outflows)
$56,500 = (5.650 Cash Outflows)
a.
Payback
Period
=
PV Factor = $88,320 $12,000 = 7.36
In Exhibit 26-4, we find that the factor 7.36 is associated with a discount rate of 6%. Thus, the
discount rate yielding a net present value of zero for I nvestment C is 6%.
E26.6
$ ?
88,320
$ 0
$ 303,700
300,000
$ 3,700
cash flows associated with I nvestment B must equal the investments original cost of $141,250.
Present value of annual net cash flows discounted at ?% for 10 years
I nvestment C
Thus, the annual cash outflows associated with the investment can be computed as follows:
($35,000 - Cash Outflows) 5.650 = $141,250
($35,000 5.650) - (5.650 Cash Outflows) = $141,250
cash flows associated with I nvestment C must equal the investments original cost of $88,320.
Thus, the discount rate associated with the investment that yields a net present value of zero can
be computed as follows:
($19,000 - $7,000) PV Factor = $88,320
$12,000 PV Factor = $88,320
$197,750 - (5.650 Cash Outflows) = $141,250
Cash Outflows = $56,500 5.650 = $10,000
$197,750 - $141,250 = (5.650 Cash Outflows)
$56,500 = (5.650 Cash Outflows)
PV Factor = $88,320 $12,000 = 7.36
In Exhibit 26-4, we find that the factor 7.36 is associated with a discount rate of 6%. Thus, the
discount rate yielding a net present value of zero for I nvestment C is 6%.
= 3 years
E26.6
Ex. 26.7 a.
$530,000
$200,000
b.
$ 517,800
24,100
$ 541,900
530,000
$ 11,900
c.
Ex. 26.8 a. $300,000
b. 3 years
c. 16 2/3%
d. $911,100
e. $11,100
Ex. 26.9 a.
[$911,100 (part d) - $900,000 investment]
This is a very complex question with no single correct answer. If all division
managers commonly overstate cash flow projections in order to obtain funding
for their proposals, it certainly would be tempting for a new manager to do so
also. However, to blatantly lie about projections is an unethical practice, and
such behavior should be avoided. If you were to make your projections as
objective as possible, and support all of your assumptions with well-
documented evidence of their reliability, you might actually have more leverage
than a competing division manager who made inflated projections without
documented support.
Less: Original cost of investment ..
Net present value ..
There are several nonfinancial issues that Northwest Records should consider.
First, musical tastes often change very quickly. As such, an estimate that the
grunge sound will remain popular for four years is only a speculative guess.
Second, even if the grunge sound remains popular, there is no guarantee that
Seattle Sound will be able to attract the best talent. Finally, the most valuable
asset that Seattle Sound possesses is its management team. This team is
ultimately responsible for signing contracts and making deals with big-name
grunge bands. It is very important for Northwest Records to establish a legal
clause that forbids Seattle Sound employees from leaving and establishing their
own competing companies.
[$300,000 cash flow (part a) 3.037] (from Exhibit 26.4)
($975,000 receipts - $675,000 cash expenses)
[$900,000 investment $300,000 cash flow (part a)]
[$75,000 income ($900,000 2)]
years discounted at a rate of 20% is $200,000 2.589
Present value of the investments $50,000 salvage value at
the end of year 4, discounted at a rate of 20% is
Total present value of all cash flows ..
Present value of net cash flows of $200,000 per year for 4
$50,000 .482 (from Exhibit 26.3)
(from Exhibit 26.4)
The payback period of the Seattle Sound investment is computed as follows:
= = 2.65 years
The net present value of the Seattle Sound investment is computed as follows:
Estimated Annual Net Cash
E26.7,8,9
b.
Ex. 26.10
a. Net present value:
Calculate depreciation expense under each alternative:
New machine ($120,000 5 years) 24,000 $
Old machine ($100,000 5 years) 20,000
Increase in depreciation of new machine 4,000 $
Calculate the incremental increase in annual income taxes resulting
from the purchase of the new machine:
Cost savings of new machine 34,000 $
Less: Increase in depreciation (see above) 4,000
Increase in pretax income 30,000 $
Income tax rate 40%
Increase in income taxes 12,000 $
Calculate the incremental increase in annual cash flow resulting from
the purchase of the new machine:
Cost of savings of new machine 34,000 $
Less: Increase in income taxes (see above) 12,000
Increase in annual cash flow 22,000 $
Calculate the tax savings resulting from the loss on the sale of the
old machine:
Book value of old machine 100,000 $
Proceeds from sale 20,000
Loss on sale of disposal 80,000 $
Income tax rate 40%
Tax savings resulting from loss on disposal 32,000 $
The net present value of the new machine can now be computed as follows:
Present value of incremental annual cash flows discounted at 12%
for five years is $22,000 3.605 (from Exhibit 26.4) 79,310 $
Present value of tax savings from loss on disposal of the old machine
discounted at 12% for 1 year is $32,000 .893 (from Exhibit 26.3) 28,576
Present value of proceeds from sale of old equipment 20,000
Total present value 127,886 $
Less: Cost of new machine 120,000
Net present value 7,886 $
There are numerous controls that might be implemented to discourage the overstatement of
capital budgeting estimates. First, whenever possible, assumptions and projections should be
well documented with objective support. Second, managers who receive funding for their
proposals should be required to submit post-implementation reports on the actual success of
their projects. Managers should be evaluated, in part, based upon the extent to which a
division achieves budget projectionsincluding capital budgeting estimates.
E26.10
Ex. 26.11 a. b.
$ 80,000 $ 20,000
70,000 70,000
$ 10,000 $ (50,000)
$ (4,000)
$ 20,000
$ 76,000
$ 40,000
Ex. 26.12
$ 80,000
32,000
$ 48,000
$ 14,000
$ 62,000

Ex. 26.13 a. NPV = ($300,000 6.71) - $2,000,000 = $13,000.
b.
c.
Net Inflow
Cash effects of depreciation
($35,000 .40)
Tax Savings at 40%
Net cash effect of sale:
($80,000 - $4,000)
The NPV is positive indicating they should purchase the MRI.
The hospital may have some commitment to the community and
community considerations are always important in hospital
investments. In addition, the number of MRIs already in operation in
the surrounding area, the financing, whether there is newer technology
on the horizon, whether it has the skilled labor to operate the MRI, etc.
are nonfinancial considerations.
Cash flow from operations:
($150,000 - $70,000)
Tax outflow at 40%
Total after tax effect on cash
(excluding depreciation)
c.
b. Perhaps the most important nonfinancial consideration for EnterTech
to consider is the future demand for portable CD players. If demand
for the product is less than five years, the investment in the new
machine is far less attractive. Management should also explore the
possibility of finding an alternative use for the machine once portable
CD players are no longer manufactured. Finally, it should evaluate any
alternative investment opportunities the company may have.
Because the decision of whether or not to invest in the new machine is
highly dependent on the cost savings estimate, EnterTech may want to
obtain a second estimate from a neutral third party. Estimates could
be obtained from sources such as consulting firms, engineers from an
outside division (that would not have a stake in the investment), or the
finance department.
($20,000 + $20,000)
Cash proceeds of sale
Book value:
[$175,000 - 3 (35,000)]
Gain (Loss) on Sale
Taxes Paid at 40%
E26.11,12,13
Ex. 26.14
5% rate 5% NPV 8% rate 8% NPV
Year 1 0.952 $142,800 0.926 $138,900
Year 2 0.907 199,540 0.857 188,540
Year 3 0.864 216,000 0.794 198,500
Year 4 0.823 144,025 0.735 128,625
Total NPV $702,365 $654,565
Ex. 26.15 a.
b.
c.
$ 91 million
29 million
$ 120 million
$ 120 million
42 million
$ 78 million
d.
$175,000
Home Depot closed 20 of its Expo stores and two Home Depot Supply stores in
2005.
Amount
$150,000
$220,000
$250,000
Home Depot charged a total of $91 million to SG&A related to the disposition of
the Expo stores. Of this total, $78 million was for asset impairment charges and
$13 million was for lease obligations. In addition, Home Depot incurred $29
million of Cost of Sales expense related to inventory markdowns in the Expo
Stores.
The tax-related impact of the charges to SG&A and inventory markdowns on
2005 annual net income are computed as follows:
Home Depot mentions that customers affected by the closings of the 20 stores
are being served by other existing Home Depot and Expo stores. Other
nonfinancial factors include the impact on suppliers, employees and
communities that the stores supported. Corporate reputation can be harmed by
large-scale or capricious store closings.
Decrease in annual pretax operating income from
impairment .C38
Less: decrease in income taxes (at 35%)
Net decrease in annual net income from impairment ..
Increase in SG&A
Increase in Cost of Sales .
Total increase in expenses ..
E26.14,15
SOLUTIONS TO PROBLEMS SET A
30 Minutes, Strong
PROBLEM 26.1A
TOYING WITH NATURE
a.
Estimated sales (80,000 units @ $6) 480,000 $
Less estimated incremental costs:
Variable manufacturing costs (80,000 units @ $2.50) 200,000 $
Fixed manufacturing costs (except depreciation) 45,000
Depreciation expense [($350,000 - $20,000) 3] 110,000
Selling and general expenses 55,000 410,000
Income before income taxes 70,000 $
Income taxes expense ($70,000 40%) 28,000
Estimated increase in annual net income 42,000 $
b. Computation of annual net cash flow:
Cash receipts 480,000 $
Less cash outlays:
Variable manufacturing costs 200,000 $
Fixed costs (other than depreciation) 45,000
Selling and general expenses 55,000
Income taxes expense 28,000 328,000
Annual net cash flow from sale of new product 152,000 $
c. (1)
$350,000
$152,000
(2)
(3) Net present value of project, discounted at 15%:
Total present value of annual net cash flows ($152,000 2.283) 347,016 $
Present value of salvage, due in three years ($20,000 .658) 13,160
Less: Amount to be invested 350,000
Net present value of this project 10,176 $
2.3 years
= 22.7%
Amount Invested
= =
TOYING WITH NATURE
Schedule of Estimated Net Income
(350,000 + $20,000) 2
42,000
Annual Net Income
Average Investment
=
Payback period:
P26.1A
PROBLEM 26.2A
MICRO TECHNOLOGY
a.
(1)
(2)
(3) Net present value, discounted at 12%:
Total present value of eight annual net cash flows ($75,000 4.968) 372,600 $
Net present value of proposal 12,600 $
(1)
(2)
Total present value of seven annual net cash flows ($76,000 4.564) 346,864 $
Present value of salvage value due in seven years ($14,000 .452) 6,328
b.
25 Minutes, Medium
Proposal 2
$30,000 ($360,000 2)
$30,000 $180,000 = 16.7%
Proposal 1
Payback period:
$360,000 $75,000 = 4.8 years
$28,000 $182,000 = 15.4%
From the information above, Proposal 1 appears to be the better investment. Although
Proposal 2 has a slightly shorter payback period, Proposal 1 is more profitable, as indicated
by the higher return on average investment and greater net present value.
$350,000 $76,000 = 4.6 years
Payback period:
$28,000 [($350,000 + $14,000) 2]
P26.2A
25 Minutes, Medium
PROBLEM 26.3A
BANNER EQUIPMENT CO.
a.
(1)
(2)
Total present value of five annual net cash flows ($60,000 3.605) 216,300 $
Present value of salvage value due in five years ($10,000 .567) 5,670
(1)
(2)
Total present value of six annual net cash flows ($60,000 4.111) 246,660 $
b.
Proposal A
Payback period:
$220,000 $60,000 = 3.7 years
$20,000 ($240,000 2)
$20,000 $120,000 = 16.7%
From the information above, Proposal B appears to be the better investment. Although
Proposal A has a shorter payback period, Proposal B is more profitable, as indicated by the
higher return on average investment and greater net present value.
$240,000 $60,000 = 4 years
$18,000 [($220,000 + $10,000) 2]
$18,000 $115,000 = 15.7%
Proposal B
Payback period:
P26.3A
25 Minutes, Medium
PROBLEM 26.4
MARENGO
a.
(1)
(2)
Total present value of 10 annual net cash flows ($80,000 5.019) 401,520 $
Present value of salvage value due in 10 years ($20,000 .247) 4,940
(1)
(2)
Net present value of proposal (10,845) $
b. Based upon the above analysis, Proposal A is the only acceptable investment of the two
proposals under consideration. Both proposals have acceptable payback periods (less than
the useful life of fixtures) and acceptable rates of return on investment (higher than
managements required 15%). However, the negative net present value of Proposal B
dictates rejection of this proposal as a possible investment. The positive net present value of
Proposal A indicates that this option is the more profitable alternative.
Note to instructor: The net present value calculation is the best of the three capital budgeting
models because it is based on cash flows and because it considers profitability and the time
value of money. Each of the other two simpler models ignores two of these factors.
Proposal B
Payback period:
$500,000 $95,000 = 5.3 years
($95,000 - $45,000) [($500,000 + $50,000) 2]
$50,000 $275,000 = 18.2%
($80,000 - $38,000) [($400,000 + $20,000) 2]
$42,000 $210,000 = 20%
Proposal A
Payback period:
$400,000 $80,000 = 5.0 years
P26.4A
25 Minutes, Medium
PROBLEM 26.5A
V.S. YOGURT
a.
(1)
(2)
Total present value of seven annual net cash flows ($750,000 4.160) 3,120,000 $
Less: Amount to be invested 3,150,000
(1)
(2)
Total present value of seven annual net cash flows ($570,000 4.160) 2,371,200 $
Present value of salvage due in seven years ($400,000 .376) 150,400
Total present value 2,521,600 $
b.
($750,000 - $450,000) ($3,150,000 2)
$300,000 $1,575,000 = 19.0%
($570,000 - $300,000) [($2,500,000 + $400,000) 2]
Proposal A
Payback period:
$3,150,000 $750,000 = 4.2 years
models because it is based on cash flows and because it considers profitability and the time value
of money. Each of the other two simpler models ignores two of these factors.
Proposal B
Payback period:
$2,500,000 $570,000 = 4.4 years
$270,000 $1,450,000 = 18.6%
Based on the above analysis, Proposal B is the only acceptable investment of the two
proposals under consideration. Although Proposal A has a slightly shorter payback period
and a higher return on average investment, the negative net present value of this proposal
dictates rejection of Proposal A. The positive net present value of Proposal B, accompanied
by an acceptable payback period and return on average investment, indicates that Proposal
B is the more profitable investment strategy.
P26.5A
30 Minutes, Strong
PROBLEM 26.6A
ROTHMORE APPLIANCE COMPANY
a.
Variable manufacturing costs (10,000 units @ $15) 150,000 $
Depreciation expense ($240,000 4) 60,000
Net income 30,000 $
Less cash outlays:
Annual net cash flow 90,000 $
c. (1)
$240,000
$90,000
(2)
$30,000
$240,000 2
Total present value of annual cash flows ($90,000 2.855) 256,950 $
Net present value of project 16,950 $
Annual Net Income
Average Investment
=
=
ROTHMORE APPLIANCE COMPANY
= 2.7 years
= 25%
Payback period:
Amount Invested
P26.6A
40 Minutes, Strong
PROBLEM 26.7A
DOCTORS
a.
$1,250,000
$243,750
The supporting calculations for the above payback figure are:
Incremental annual revenue of investment
Less: Incremental annual expenses of investment
Incremental annual income of investment
Add: Depreciation expense
Incremental annual cash flow of investment

b.
$100,000
$675,000
$1,250,000 + $100,000
2
=
=
*Depreciation expense: [$1,250,000 - $100,000 ] 8 years = $143,750
Average Investment
Average Investment
2
Average Investment
= = 14.81%
Payback period:
Estimated Annual Net Cash Flow
= = 5.13 years
Thus, the MRIs return on average investment is:
= $675,000
P26.7A
PROBLEM 26.7A
DOCTORS
800,000 $
700,000
100,000 $
143,750*
243,750 $
= 14.81%
Payback period:
= 5.13 years
= $675,000
P26.7A
PROBLEM 26.7A
DOCTORS (concluded)
c. Net present value:
The discounted present value of the incremental annual cash flow of
the investment (see part a) discounted at 12% for 8 years is
$243,750 4.968 (from Exhibit 26.4) 1,210,950 $
The discounted present value of the investments salvage value
discounted at 12% for 8 years is $100,000 .404 (from Exhibit 26.3) 40,400
Discounted present value of all cash flows 1,251,350 $
Less: Cost of investment 1,250,000
As shown above, the net present value of the MRI investment is only
$1,350. Thus, we may conclude that the investments actual rate of
return is only slightly greater than 12%.
d. Some of the nonfinancial factors that the doctors should consider include (1) the pace at
which MRI technology is changing, (2) changes in legislation pertaining to government
funding of medical benefits, (3) legal considerations related to the formation and operation
of a corporation, (4) their ethical responsibility to provide quality health care to rural areas,
(5) alternative investment opportunities, and (6) their eligibility to acquire grants and other
sources of external financing for this activity.
P26.7A (p.2)
50 Minutes, Strong
PROBLEM 26.8A
JEFFERSON MOUNTAIN
a.
$125,000
$31,250
The supporting calculations are:
Incremental annual revenue of investment 40,000 $
Less: Incremental annual expenses of investment 15,000
Incremental annual income of investment 25,000 $
Add: Depreciation expense 6,250*
Incremental annual cash flow of investment 31,250 $

$180,000
$40,000
The supporting calculations for the payback period figure are:

*Depreciation expense: $180,000 36 years = $5,000
Chair Lift
= = 4.5 years
Payback period:
Snow-Making Equipment
= 4 years =
P26.8A
PROBLEM 26.8A
JEFFERSON MOUNTAIN (continued)
b.
$125,000 + $0
2
$25,000
$62,500
$35,000
$90,000
$31,250 4.870 (from Exhibit 26.4) 152,188 $
Less: Cost of investment 125,000
Chair Lift
$40,000 4.993 (from Exhibit 26.4) 199,720 $
2
Average
Investment
=
Average
Investment
= 40%
=
Average Investment
Thus, the return on average investment is:
2
$180,000 + $0
2
= $90,000
= = $62,500
= = 38.89%
Average Investment
Chair Lift
Average
Investment
Average
Investment
=
=
P26.8A (p.2)
PROBLEM 26.8A
JEFFERSON MOUNTAIN (concluded)
d.
e.
The management of Jefferson Mountain must decide which investment opportunity will
best serve its customers. Thus, it must try to determine if adequate snow coverage with long
lift lines is better than short lift lines with limited snow coverage. A marketing study could
be conducted to gain a better understanding of customer expectations. In addition,
management should also consider the condition of the resorts existing chair lifts, recent
weather patterns, and alternative investment opportunities.
It is likely that management will elect to invest in snow-making equipment. This investment
has the shortest payback period, a greater return on average investment, and a higher net
present value. Skiers are more likely to tolerate long lift lines if snow conditions are good
than short lift lines with poor snow conditions. Once the equipment has been installed,
management can begin to make plans regarding the future investment in a high-speed chair
lift.
P26.8A (p.3)
45 Minutes, Strong
PROBLEM 26.9A
SONIC, INC.
a.
$300,000
$100,000

$240,000
$70,000
The supporting calculations for the payback figure are:

Payback period:
Computer Chip Equipment
= 3 years =
Software Bank I nstallation
= = 3.4 years
P26.9A
PROBLEM 26.9A
SONIC, INC. (continued)
b.
$300,000 + $0
2
$50,000
$150,000
$240,000 + $0
2
$30,000
$120,000
$100,000 3.784 (from Exhibit 26.4) 378,400 $
Software Bank Installation
$70,000 3.784 (from Exhibit 26.4) 264,880 $
=
Average Investment
= 25%
2
= $120,000
Average
Investment
Average
Investment
=
=
= = $150,000
Average
Investment
Software Bank I nstallation
=
Average Investment
= 33.33%
2
Average
Investment
=
P26.9A (p.2)
PROBLEM 26.9A
SONIC, INC. (concluded)
d.
e.
f.
There are several nonfinancial considerations worth mentioning. First, the company must
try to determine which medium the customers are most likely to use. Second, it must try to
determine future industry trends regarding software distribution. Third, it must evaluate
which medium provides the most protection against piracy and theft. Fourth, it must
consider the risk of having their software bank installation infected with a computer virus.
Finally, the company should consider whether other investment opportunities are available.
If Sonic invests in the software bank, there will no longer be a need for employees to load
programs onto disks of any type, process orders, or package and ship program disks. If the
employees and managers who currently perform these tasks believe they may be terminated
if the investment is made, they will likely be biased against it and underestimate its benefits.
It is likely that management will elect to invest in the computer chip. In addition to being an
accepted method of software distribution, the investment has the shortest payback period, a
greater return on average investment, and a higher net present value.
P26.9A (p.3)
SOLUTIONS TO PROBLEMS SET B
30 Minutes, Strong
PROBLEM 26.1B
MONSTER TOYS
a.
Variable manufacturing costs (100,000 units @ $3.00) 300,000 $
Depreciation expense [($400,000 - $10,000) 3] 130,000
Estimated increase in annual net income 189,000 $
Less cash outlays:
Annual net cash flow from sale of new product 319,000 $
c. (1)
$400,000
$319,000
(2)
Total present value of annual net cash flows ($319,000 2.402) 766,238 $
Present value of salvage, due in three years ($10,000 .712) 7,120
Net present value of this project 373,358 $
= 92.2%
Annual Net Income
Average Investment
=
189,000
($400,000 + $10,000) 2
= = 1.25 years
MONSTER TOYS
Payback period:
Amount Invested
P26.1B
PROBLEM 26.2B
MACRO TECHNOLOGY
a.
(1)
(2)
Total present value of ten annual net cash flows ($80,000 5.019) 401,520 $
(1)
(2)
Total present value of eight annual net cash flows ($82,000 4.487) 367,934 $
Present value of salvage value due in eight years ($20,000 .327) 6,540
b.
$37,000 $200,000 = 18.5%
From the information above, Proposal 1 appears to be the better investment. Although
Proposal 2 has a slightly shorter payback period and a higher return on average investment,
it also has a negative net present value and consequently it is not getting a 15% return.
$380,000 $82,000 = 4.6 years
Payback period:
$37,000 [($380,000 + $20,000) 2]
25 Minutes, Medium
Proposal 2
$40,000 ($400,000 2)
$40,000 $200,000 = 20%
Proposal 1
Payback period:
$400,000 $80,000 = 5 years
P26.2B
25 Minutes, Medium
PROBLEM 26.3B
FLAGG EQUIPMENT CO.
a.
(1)
(2)
Total present value of six annual net cash flows ($82,000 3.784) 310,288 $
Present value of salvage value due in six years ($20,000 .432) 8,640
(1)
(2)
Total present value of seven annual net cash flows ($65,000 4.160) 270,400 $
b. From the information above, Proposal A appears to be the better investment. Proposal A
has a shorter payback period and is more profitable, as indicated by the higher return on
average investment and greater net present value.
Proposal A
Payback period:
$260,000 $82,000 = 3.2 years
$280,000 $65,000 = 4.3 years
$42,000 [($260,000 + $20,000) 2]
$42,000 $140,000 = 30%
Proposal B
Payback period:
$25,000 ($280,000 2)
$25,000 $140,000 = 17.9%
P26.3B
25 Minutes, Medium
PROBLEM 26.4B
TANGO
a.
(1)
(2)
(1)
(2)
b.
($75,000 - $24,000) [($250,000 + $10,000) 2]
$51,000 $130,000 = 39.2%
Proposal A
Payback period:
$250,000 $75,000 = 3.3 years
models because it is based on cash flows and because it considers profitability and the time
value of money. Each of the other two simpler models ignores two of these factors.
Based upon the above analysis, Proposal A is the only acceptable investment of the two
proposals under consideration. Both proposals have acceptable payback periods (less than
the useful life of fixtures). However, the negative net present value and unacceptable rate
of return on investment (lower than managements required 12%) of Proposal B dictates
rejection of this proposal as a possible investment. The positive net present value and
acceptable rate of return on investment (higher than managements required 12%) of
Proposal A indicates that this option is the more profitable alternative.
Proposal B
Payback period:
$300,000 $50,000 = 6.0 years
($50,000 - $36,000) [($300,000 + $40,000) 2]
$14,000 $170,000 = 8.2%
P26.4B
25 Minutes, Medium
PROBLEM 26.5B
I.C. CREAM
a.
(1)
(2)
Total present value of eight annual net cash flows ($800,000 4.968) 3,974,400 $
(1)
(2)
Total present value of eight annual net cash flows ($700,000 4.968) 3,477,600 $
Present value of salvage due in eight years ($200,000 .404) 80,800
Total present value 3,558,400 $
b.
Proposal A
Payback period:
$4,000,000 $800,000 = 5 years
($800,000 - $500,000) ($4,000,000 2)
$300,000 $2,000,000 = 15%
models because it is based on cash flows and because it considers profitability and the time value
of money. Each of the other two simpler models ignores two of these factors.
($700,000 - $350,000) [($3,000,000 + $200,000) 2]
$350,000 $1,600,000 = 21.9%
Based on the above analysis, Proposal B is the only acceptable investment of the two
proposals under consideration. Although Proposal A has an acceptable payback period and
return on average investment, the negative net present value of this proposal dictates
rejection of Proposal A. The positive net present value of Proposal B, accompanied by a
shorter payback period and a higher return on average investment, indicates that Proposal B
is the more profitable investment strategy.
Proposal B
Payback period:
$3,000,000 $700,000 = 4.3 years
P26.5B
30 Minutes, Strong
PROBLEM 26.6B
CAFIELD APPLIANCE COMPANY
a.
Variable manufacturing costs (15,000 units @ $18) 270,000 $
Depreciation expense ($300,000 5) 60,000
Net income 94,500 $
Less cash outlays:
Annual net cash flow 154,500 $
c. (1)
$300,000
$154,500
(2)
$94,500
$300,000 2
Total present value of annual cash flows ($154,500 3.605) 556,973 $
Net present value of project 256,973 $
Average Investment
= 1.9 years
= 63%
=
=
Amount Invested
CAFIELD APPLIANCE COMPANY
Payback period:
Annual Net Income
P26.6B
40 Minutes, Strong
PROBLEM 26.7B
DOCTORS
a.
$1,500,000
$244,444

b.
$100,000
$850,000
*Depreciation expense: [$1,500,000 - $200,000 ] 9 years = $144,444
2
=
=
Average Investment
Average Investment
Payback period:
= = 6.14 years
$1,500,000 + $200,000
2
Average Investment
= = 11.76%
Thus, the MRIs return on average investment is:
= $850,000
P26.7B
PROBLEM 26.7B
DOCTORS
900,000 $
800,000
100,000 $
144,444*
244,444 $
Payback period:
= 6.14 years
= 11.76%
= $850,000
P26.7B
PROBLEM 26.7B
DOCTORS (concluded)
$244,444 4.772 (from Exhibit 26.4) 1,166,487 $
The discounted present value of the investments salvage value
discounted at 15% for 9 years is $200,000 .284 (from Exhibit 26.3) 56,800
Discounted present value of all cash flows 1,223,287 $
Less: Cost of investment 1,500,000
Net present value (276,713) $
As shown above, the net present value of the MRI investment is negative. Thus,
we may conclude that the investments actual rate of return is less than 15%.
d. Some of the nonfinancial factors that the doctors should consider include (1) the pace at
which MRI technology is changing, (2) changes in legislation pertaining to government
funding of medical benefits, (3) legal considerations related to the formation and operation
of a corporation, (4) their ethical responsibility to provide quality health care to rural areas,
(5) alternative investment opportunities, (6) their eligibility to acquire grants and other
sources of external financing for this activity, (7) the possibility of increasing fees, and (8)
including more doctors in the corporation.
P26.7B (p.2)
50 Minutes, Strong
PROBLEM 26.8B
MADISON MOUNTAIN
a.
$150,000
$45,000

$200,000
$48,000
The supporting calculations for the payback period figure are:

Payback period:
= 3 1/3 years =
Chair Lift
= = 4.17 years
P26.8B
PROBLEM 26.8B
MADISON MOUNTAIN (continued)
b.
$150,000 + $0
2
$30,000
$75,000
$200,000 + $0
2
$38,000
$100,000
$45,000 4.192 (from Exhibit 26.4) 188,640 $
Chair Lift
The discounted present value of the incremental annual cash flow
of the investment (see part a) discounted at 20% for 20 years is
$48,000 4.870 (from Exhibit 26.4) 233,760 $
=
Average Investment
= 38%
2
= $100,000
Average
Investment
Average
Investment
=
=
= = $75,000
Average
Investment
Chair Lift
=
Average Investment
= 40%
2
Average
Investment
=
P26.8B (p.2)
PROBLEM 26.8B
MADISON MOUNTAIN (concluded)
d.
e.
The management of Madison Mountain must decide which investment opportunity will best
serve its customers. Thus, it must try to determine if adequate snow coverage with long lift
lines is better than short lift lines with limited snow coverage. A marketing study could be
conducted to gain a better understanding of customer expectations. In addition, management
should also consider the condition of the resorts existing chair lifts, recent weather patterns,
and alternative investment opportunities.
It is likely that management will elect to invest in snow-making equipment. This investment
has the shortest payback period, a greater return on average investment, and a higher net
present value. Skiers are more likely to tolerate long lift lines if snow conditions are good
than short lift lines with poor snow conditions. Once the equipment has been installed, the
management can begin to make plans regarding the future investment in a high-speed chair
lift.
P26.8B (p.3)
45 Minutes, Strong
PROBLEM 26.9B
BOOM, INC.
a.
$500,000
$240,000

$350,000
$190,000
The supporting calculations for the payback figure are:

Program Bank I nstallation
= = 1.84 years
Payback period:
Memory Stick
= 2.08 years =
P26.9B
PROBLEM 26.9B
BOOM, INC. (continued)
b.
$500,000 + $0
2
$140,000
$250,000
$350,000 + $0
2
$120,000
$175,000
Memory Stick
$240,000 3.605 (from Exhibit 26.4) 865,200 $
Program Bank Installation
$190,000 3.605 (from Exhibit 26.4) 684,950 $
= 56%
Memory Stick
2
Average
Investment
=
= = $175,000
= = $250,000
Average
Investment
Program Bank I nstallation
=
Average Investment
=
Average Investment
= 68.6%
2
Average
Investment
Average
Investment
=
P26.9B (p.2)
PROBLEM 26.9B
BOOM, INC. (concluded)
d.
e.
f.
There are several nonfinancial considerations worth mentioning. First, the company must
try to determine which medium the customers are most likely to use. Second, it must try to
determine future industry trends regarding software distribution. Third, it must evaluate
which medium provides the most protection against piracy and theft. Fourth, it must
consider the risk of having their program bank installation infected with a computer virus.
Finally, the company should consider whether other investment opportunities are available.
If Boom invests in the program bank, there will no longer be a need for employees to load
programs onto disks of any type, process orders, or package and ship program disks. If the
employees and managers who currently perform these tasks believe they may be terminated
if the investment is made, they will likely be biased against it and underestimate its benefits.
Both are excellent investments with low payback periods, high return on investments and
positive net present values. The ultimate decision should be a marketing one.
P26.9B (p.3)
SOLUTIONS TO CRITICAL THINKING CASES
a.
b.
25 Minutes, Strong
Present value of estimated incremental annual cash flows for 10 years:
$114,000 5.019 (Exhibit 26.4) ..
CASE 26.1
THE CASE OF THE COSTLY LASER
Amount to be invested (to be paid immediately) .
Net present value of proposal
The cost of the laser printer is $1,300,000, not $2,500,000 as Adams suggests. Adams is
including the $1,200,000 after-tax loss on the sale of the existing equipment as part of the cost
of the laser printer. This $1,200,000 is part of the cost of the old equipment, not of the laser
printer. The $1,200,000 is a sunk costthat is, it has already been incurred and exists
regardless of whether the existing equipment is sold or continued in use. The cost of the laser
printer consists only of the $1,300,000 price which must be paid to purchase it.
Present value of proceeds from sale of existing equipment
Present value of tax savings from loss on disposal of existing equipment,
realized in 1 year: $800,000 .870 (Exhibit 26.4) ..
(received immediately) .
Total present value
Case 26.1
SOLUTIONS TO CRITICAL THINKING CASES
$ 572,166
200,000
696,000
$ 1,468,166
1,300,000
$ 168,166
CASE 26.1
THE CASE OF THE COSTLY LASER
The cost of the laser printer is $1,300,000, not $2,500,000 as Adams suggests. Adams is
including the $1,200,000 after-tax loss on the sale of the existing equipment as part of the cost
of the laser printer. This $1,200,000 is part of the cost of the old equipment, not of the laser
printer. The $1,200,000 is a sunk costthat is, it has already been incurred and exists
regardless of whether the existing equipment is sold or continued in use. The cost of the laser
printer consists only of the $1,300,000 price which must be paid to purchase it.
Case 26.1
60 Minutes, Strong
CASE 26.2
GRIZZLY COMMUNITY HOSPITAL
a.
$4,500,000
$525,000

$300,000
$2,250,000
Net Present Value
the investment (see above) discounted at 12% for 20 years is
$525,000 7.469 (from Exhibit 26.4)
Less: Cost of investment
Net present value

The negative net present value computed above indicates that
expected return of the center is less than the 12% return required
by the hospital.
2
$4,500,000 + $0
2
= $2,250,000
=
=
*Depreciation expense: 4,500,000 20 years = $225,000
Average Investment
Average Investment
Average Investment
= = 13.33%
Relevant financial measures introduced in the chapter include:
Payback period
= = 8.57 years
Case 26.2
CASE 26.2
GRIZZLY COMMUNITY HOSPITAL
1,150,000 $
850,000
300,000 $
225,000*
525,000 $
3,921,225 $
4,500,000
(578,775) $
= $2,250,000
= 13.33%
Relevant financial measures introduced in the chapter include:
Payback period
= 8.57 years
Case 26.2
CASE 26.2
b.
c.
There are many nonfinancial issues related to this decision. Questions that should be
addressed include (1) Would those patients who now travel 300 miles for treatment utilize
the Grizzly facility? (2) Is the staff of Grizzly trained to deliver quality dialysis care to
kidney patients? (3) Is a helicopter that would provide emergency care to rural areas a
better use of hospital funds? (4) Does a hospital have an ethical responsibility to deliver
comprehensive services even if some are unprofitable? (5) Is a hospital a business? (6)
What will be the impact on the hospital if one or more physicians move out of the area if a
dialysis center is not built? (7) What state, federal, or private funding is available for this
type of facility? (8) What alternative investment opportunities does the hospital have?
The estimates of the revenues and costs associated with the dialysis center were provided
by the physicians, who are strongly in favor of building the center. Due to their position on
the issue, these estimates may overstate the revenues and understate the costs of the center.
To make a well-informed decision, neutral estimates should be obtained from an outside
consulting firm or the hospitals finance division.
GRIZZLY COMMUNITY HOSPITAL (concluded)
Case 26.2 (p.2)
20 Minutes, Medium CASE 26.3
INTERNATIONAL INVESTMENTS IN OUTSCOURCING
BUSINESS WEEK
a.
b.
Lower cost does not always mean gains in efficiency implies that the cash flow savings
obtained from lower cost inputs overseas (labor for example) may be offset by higher costs
and related cash flows due to reduced productivity. Often, lower labor costs go hand in
hand with less skilled labor. A lower skilled labor force will result in lower productivity
and efficiency.
Although companies have been known to undertake transfer of knowledge between
current and future employees, there are significant ethical concerns about asking current
employees to train their offshore replacements. There is the potential for the employees to
be less than forthcoming about the knowledge required to successfully complete their job.
Thus, transfer of information may be incomplete or fraudulent. That is an ethical problem
on the part of the employees. The company bears some ethical responsibility in asking the
employees to share knowledge they may have gained over many years of work and
training, without additional compensation.
Choosing to run your own offshore operation versus outsourcing the management of that
operation can have significant cash flow implications. It is likely to be more costly to
manage your own offshore operation. However, gains in efficiency, productivity and
quality can offset those initial costs.
Current employees can hinder progress in completing an international investment if they
believe their jobs are ultimately in jeopardy. Creating a mechanism for full
communication and transparency is key to getting employees on board. In addition, if jobs
are being transferred overseas, then mechanisms for retraining and retaining current
employees will help make sure they are onboard. Of course these initiatives have
associated cash flows.
Finally, treating your partners as equals will result in tapping into your partners
knowledge which will far exceed your domestic-based understanding of the international
setting. That knowledge could have significant cash flow implications if it saves missteps in
the investment process from occurring.
Case 26.3
CASE 26.4
INTERNET
a.
b.
c.
There are several capital investment decisions highlighted in the history section, including
the construction of a large mail order plant in Chicago in 1906, which was then the largest
business building in the world, and the subsequent construction of the Sears Tower in
1973. The establishment of the Allstate Insurance Company, Dean Witter Investments, the
acquisition of K-Mart, and the Discover Card, were also capital investment decisions
focused on expanding the scope of Sears operations.
In its decisions to invest in businesses not involved in retail sales (such as Allstate
Insurance), Sears would have had to consider whether these businesses would fit with its
current operations and whether they could be managed effectively. Customer preferences
would have also been analyzed to determine if they would be willing to buy other services
(such as investment services) from a company that primarily sold retail goods.
Employees working in the store under consideration would most likely overestimate the
benefits of additional capital investments, while employees working in other locations
would likely underestimate the benefits.
25 Minutes, Easy
SEARS, ROEBUCK AND COMPANY
Case 26.4
CASE 26.5
a.
b.
The ethical violations identified in the Red Robin case are two particular instances. First,
the CEO employed corporate assets for his own personal use. When the airplane was
purchased, a capital investment analysis was performed to assess its net present value.
Conversion of assets for personal use were not part of those computations. If they had been
part of those computations, perhaps the investment would not have been made. The second
issue discussed in the story is the CEOs conflict of interest because he was an owner of a
supplier of the company. Again, if the ownership variable becomes part of the decision
process then the economics illustrated by the present value computations may be
undermined and the best NPV project may not be chosen.
30 Minutes, Medium
GOVERNANCE AND CAPITAL BUDGETING CONFLICTS
Student answers will vary considerably. However, given recent evidence of earnings
management and outright fraud at companies like Enron and WorldCom, it is difficult to
believe that improved corporate governance designed to safeguard company assets will not
play a role in improving capital budgeting processes.
ETHICS, FRAUD & CORPORATE GOVERNANCE
Case 26.5

Chapter 26 - Capital Budgeting

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