CHAPTER 20 CAPITAL BUDGETING QUESTIONS

20-1 20-2 The three major steps in capital budgeting decisions are: project identification and definition, evaluation and selection, and monitoring and review. 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. 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

20-3

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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.

20.5Direct 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 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.

20-7

20.8Among the limitations of the payback period technique are its failure to consider an investment projects 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 projects 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 projects entire useful years.

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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 firms 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 nonquantitative 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 firms 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 managements 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.

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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 firms 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: Depreciation expense: Net effect on cash outflow $50,000 x (1 - 20%) = $40,000 $30,000 x 20% = <6,000> $34,000

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20.24 Basic Capital Budgeting Techniques (10 min) a. Project A:

Payback Period =

$5,000 = 2.78 years $1,800

Or, 2 years and 10 months b. Year 1 2 3 4 Net Cash Inflow $ 500 1,200 2,000 2,500 Cumulative Net Cash Inflow $ 500 1,700 3,700

Project B: Payback period:

Payback Period = 3 +

($5,000 $3,700 ) = 3.52 years $2,500

Or, 3 years and 7 months c. Depreciation expense per year: $5,000 5 = $1,000 Taxable income each year: $2,500 - $1,000 = $1,500 Income taxes each year: $1,500 x 25% = $375 Annual after-tax net cash inflow: $2,500 - $375 = $2,125 Project C Payback period:

Payback Period =

$5,000 = 2.35 years $2,125

Or, 2 years and 5 months

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20-24 (Continued) d. (a) Depreciation expense per year: ($5,000 - $500) 5 = $900 Taxable income: Sales $4,000 Expenses: Cash expenditures $1,500 Depreciation 900 2,400 Operating income before taxes $1,600 Income taxes (25%) 400 Net after taxes income $1,200 Book rate of return = $1,200 $5,000 = 24% (b) Average book value = ($5,000 + $500) 2 = $2,750 Book rate of return = $1,200 $2,750 = 43.64% e. Project A: Project B: Year Net Cash Inflow 0 1 $ 500 2 1,200 3 2,000 4 2,500 5 2,000 Net Present Value Project C: $1,800 x 3.993 - $5,000 = 8% discount Factor .926 .857 .794 .735 .681 $2,187

Present Value <$5,000> 463 1,028 1,588 1,838 1,362 $1,279 $3,485

$2,125 x 3.993 - $5,000 =

Project D: Present value of cash inflows: Year 1 through 4 ($1,200 + $900) x 3.312 = Year 5 (2,100 + $500) x 0.681 = Present value of cash inflows Initial investment 5,000 Net present value

$6,955 1,771 $8,726 $3,726

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20-25 Cost Of Capital (10 min) a. Bond interest before taxes Income taxes on bond interest After-tax bond interest Market value of bond: After-tax cost of bond: b. c. $3 $30 = 10% Interest Total Average Market Cost of Value Weight Capital $ 5,500,000 0.275 1.58% 6,000,000 8,500,000 $20,000,000 0.300 0.425 1.000 3.00% 8.50% 13.08% Weighted $5,000,000 x 110% = $315,000 $5,500,000 = $5,000,000 x 9% = $450,000 x 30% = $450,000 135,000 $315,000 $5,500,000 5.73%

After-tax or Rate of Dividend Expected Book Value Rate Return Bond $5,000,000 9% 5.73% Preferred Stock 5,000,000 10% 10.00% Common Stock 500,000 20.00% Total $10,500,000

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20-26 Future And Present Values (5 min) a. 1. The Excel function is FV (0.03, 600, 0, 24, 0) The output is $1,209,333,448. 2. FV(.04, 600, 0, 24, 0) = $398,304,149,423 3. a. b. FV (0.015, 1200, 0, 24, 0) = $1,378,675,128 FV (0.02, 1200, 0, 24, 0) = $501,669,104,924

4. FV(.04, 12, 0, 9,500,000,000, 0) = $15,209,806,076 b. 1. $25.2 x 5.65 = $142.38 millions 2. $25.2 + $25.2 x 5.328 = $159.4656 millions 3. $25.2 x (1 45%) x 5.65 = $78.309 millions

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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 = $101,440 NPV = $101,440 - $60,000 = $41,440 2. Net cash inflow before depreciation $32,000 Depreciation expense 15,000 Increase in net income before taxes $17,000 Income 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 = $85,273 NPV = $85,273 - $60,000 = $25,273 3. Double-declining balance depreciation Beginning Depreciation Accumulated Year Book Value Expense Depreciation 0 1 $60,000 $30,000 $30,000 2 30,000 15,000 45,000 3 15,000 7,500 52,500 4 7,500 7,500 60,000 Ending Book Value $60,000 30,000 15,000 7,500 0

Net 30% After-tax 10% Cash Depreciation Taxable Income Net Cash Discount Present Year Inflow Expense Income Taxes Inflow Factor Value 0 <$60,000> 1 $32,000 $30,000 $ 2,000 $ 600 $31,400 0.909 28,543 2 32,000 15,000 17,000 5,100 26,900 0.826 22,219 3 32,000 7,500 24,500 7,350 24,650 0.751 18,512 4 32,000 7,500 24,500 7,350 24,650 0.683 16,836 Net Present Value 26,110

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20-27 (Continued-2) b. 1. $60,000 = $32,000 x A?, 4 A?, 4 = 1.875, which has a rate of return greater than 30%. 2. $60,000 = $26,900 x A?, 4 A?, 4 = 2.230, which has a discount rate falls between 25% and 30% Discount Rate 25% 25%2.362 ? 30% Difference 5% ? 2.166 0.196 0.132 Discount Factor 2.362 2.230

Internal rate of return:

25 % +

0.132 5% = 28 .37 % 0.196

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20-28 Basic Capital Budgeting Techniques: Uniform Net cash inflows (10 min) 1. a. Payback period: $500,000 $120,000 = 4.17 years, or 4 years and 2 months b. Book rate of return: Effect of the investment on net income in each of the next 10 years: Increase in net cash inflow Depreciation expense $500,000 ) 10 = Increase in net income (a) On initial investment: (b) On average investment: Average investment: Book rate of return: $120,000 50,000 $ 70,000 14%

$70,000 ) $500,000 =

($500,000 + 0) ) 2 = $250,000 $70,00 $250,000 = 28%

c. NPV: Present value of net cash inflows: $120,000 x 5.65 = $678,000 Initial investment <500,000> Net present value $178,000

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20-28 (Continued-1) d. Present value payback period: Year 0 1 2 3 4 5 6 7 Present Value of Net cash inflow <$500,000> 107,160 95,640 85,440 76,320 68,040 60,840 54,240 Cumulative Cash Flow <$500,000> < 392,840> < 297,200> < 211,760> < 135,440> < < 67,400> 6,560> 47,680

6 years +

$6,560 = 6.12 years (6 years 2 months) $54,240

e. Internal rate of return: PV of net cash inflows At 20%: $120,000 x 4.192 $503,040 At 25%: $120,000 x 3.571 = 428,520 Difference in PV with 5% difference in discount rate $ 74,520

Internal Rate of Return = 20% +

$503,040 - $500,000 5% = 20.20% $74,520

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20-28 (Continued-2) 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) = $678,027 and 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) = $678,027 Determine the NPV by subtracting the investment, $678,027 - $500,000 = $178,027

initial

or, Insert ! Function ! Financial-Cash Flow ! @NETPV @NETPV (a1, a3.A12, A2) = $178,027 For IRR: Insert ! Function ! Financial- Annuity ! @IRATE @ IRATE (10, -120000, 500000, 0) = .2018 or, Insert ! Function ! Financial-Cash Flow ! @IRR @IRR (.1, a2.A12) = .2018
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20.29 Basic Capital Budgeting Techniques: Uneven Net cash inflow with Taxes (40 min) 1. a. Payback period:
Year 0 1 2 3 4 5 6 7 8 9 10 Total Net Cash Inflow <500,000> 50,000 80,000 120,000 200,000 240,000 300,000 270,000 240,000 120,000 40,000 <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <500,000> 0 30,000 70,000 150,000 190,000 250,000 220,000 190,000 70,000 <10,000> 1,160,000 0 <9,000> <21,000> <45,000> <57,000> <75,000> <66,000> <57,000> <21,000> 3,000 <348,000> 0 21,000 49,000 105,000 133,000 175,000 154,000 133,000 49,000 <7,000> 812,000 50,000 71,000 99,000 155,000 183,000 225,000 204,000 183,000 99,000 43,000 Depreciation Expense Taxable Income Saving or <Expense> on Income Tax Net Aftertax Income <Loss> Net After-tax Cash Inflow Cumulative Net After-tax cash inflow <500,000> <450,000> <379,000> <280,000> <125,000> 58,000

Payback Period = 4 years +

$125,000 = 4.68 years $183,000

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20-29 (Continued-1) b. Average net income of the investment period: $812,000/10 = Book rate of return: a. On initial investment: $81,200/$500,000 = b. On average investment: Average investment: ($500,000 + 0)/2 = $250,000 Book rate of return: $81,200/$250,000 = c. Net present value: Year 1 2 3 4 5 6 7 8 9 10 Total NPV = $703,866 - $500,000 = $203,866 Net After-tax cash inflow $50,000 71,000 99,000 155,000 183,000 225,000 204,000 183,000 99,000 43,000 Discount Factor at 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 Present Value of Net cash inflow $44,650 56,587 70,488 98,580 103,761 114,075 92,208 73,932 35,739 13,846 $703,866 $81,200 16.24% 32.48%

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20-29 (Continued-2) d. Internal rate of return: Year 1 2 3 4 5 6 7 8 9 10 Total Net Aftertax cash inflow $50,000 71,000 99,000 155,000 183,000 225,000 204,000 183,000 99,000 43,000 18% PV of Net Discount cash inflow Factor at 18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 $42,350 50,978 60,291 79,980 79,971 83,250 64,056 48,678 22,275 8,213 $540,042 20% Discount Factor 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 PV of Net cash inflow at 20% $41,650 49,274 57,321 74,710 73,566 75,375 56,916 42,639 19,206 6,966 $497,623 $540,042 $497,623 $ 42,419

PV of net cash inflows at 18%: PV of net cash inflows at 20%: Difference in PV with 2% difference in discount rate Internal rate of return =

18% +

$540,042 - $500,000 $42,419

2% = 19.89%

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2. 1 2 3 4 5 6 7 8 9 10 11 12 13

20-29 (Continued-3) A Year 0 1 2 3 4 5 6 7 8 9 10 Total B Net Cash Inflow <500,000> 50,000 80,000 120,000 200,000 240,000 300,000 270,000 240,000 120,000 40,000 <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <50,000> <500,000> 0 30,000 70,000 150,000 190,000 250,000 220,000 190,000 70,000 <10,000> 1,160,000 0 <9,000> <21,000> <45,000> <57,000> <75,000> <66,000> <57,000> <21,000> 3,000 <348,000> 0 21,000 49,000 105,000 133,000 175,000 154,000 133,000 49,000 <7,000> 812,000 50,000 71,000 99,000 155,000 183,000 225,000 204,000 183,000 99,000 43,000 C Depreciation Expense D Taxable Income E Saving or <Expense> on Income Tax F Net Aftertax Income <Loss> G Net Aftertax Cash Inflow

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20-29 (Continued-4) 2. NPV Microsoft Excel: Insert ! Function ! Financial ! NPV = NPV(0.12, b2, f3:f12) = $181,948 (Notice this answer is off by $21,918. This discrepancy can be mitigated if you add 0 to Cell f13, as shown below) Or, Insert ! Function ! Financial ! NPV = NPV(0.12, f3:f13) = $703,781 and then determining the NPV by subtracting the initial investment from the output, $703,781 - $500,000 = $203,781 For IRR: Insert ! Function ! Financial ! IRR = IRR(f2:f12) = 20% (-500,000 in cell f2) Quattro Pro: For NPV: Insert ! Function ! Financial- Cash Flow ! @NPV @NPV (.12, f3:f12, 1) = $203,781 (-500000 in f2) For IRR: Insert ! Function ! Financial-Cash Flow ! @IRR @IRR (.1, f2:f12) = .1988

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20-30 Basic Capital Budgeting Techniques: Uneven Net cash inflows with MACRS (40 min) 1. Payback period: Year 0 1 2 3 4 5 6 7 8 9 10 Total Net Cash Flow Return <500,000> 50,000 80,000 120,000 200,000 240,000 300,000 270,000 240,000 120,000 40,000 <100,000> <160,000> <96,000> <57,600> <57,600> <28,800> 0 0 0 0 <50,000> <80,000> 24,000 142,400 182,400 271,200 270,000 240,000 120,000 40,000 15, 000 24,000 <7,200> <42,720> <54,720> <81,360> <81,000> <72,000> <36,000> <12,000> <348,000> <35,000> <56,000> 16,800 99,680 127,680 189,840 189,000 168,000 84,000 28,000 812,000 65,000 104,000 112,800 157,280 185,280 218,640 189,000 168,000 84,000 28,000 1,312,000 Depreciation Expense Taxable Income <Loss> Income Tax Expense <Saving> After-tax Net After-tax Net Income cash inflow <Loss> Cumulative After-tax Net cash inflow <500,000> <435,000> <331,000> <218,200> < 60,920> 124,360

<500,000> 1,160,000

Payback Period = 4 years +

$60,920 = 4.33 years $185,280

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20-30 (Continued-1) 2. Book rate of return: Average net income per period: Book rate of return: a. On initial investment: b. On average investment: Computation of Average investment: Book Value Year Beginning of Depreciation End of Average the Year the Year 1 $500,000 $100,000 $400,000 $450,000 2 400,000 160,000 240,000 320,000 3 240,000 96,000 144,000 192,000 4 144,000 57,600 86,400 115,200 5 86,400 57,600 28,800 57,600 6 28,800 28,800 0 14,400 7 0 0 0 8 0 0 0 9 0 0 0 10 0 0 0 Total $500,000 $1,149,200 Average investment: $1,149,200/10 = $114,920 Book rate of return: $81,200/$114,920 = 70.66% $81,200/$500,000 = 16.24% $812,000/10 = $81,200

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20-30 (Continued-2) 3. Net present value: Year 1 2 3 4 5 6 7 8 9 10 Total After-tax Net cash inflow $65,000 104,000 112,800 157,280 185,280 218,640 189,000 168,000 84,000 28,000 Discount Factor at 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 PV of Net cash inflow $58,045 82,888 80,314 100,030 105,054 110,850 85,428 67,872 30,324 9,016 $729,821 NPV = $729,821 - $500,000 = $229,821

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20-30 (Continued-3) 4. Internal rate of return: Year After-tax Net cash Inflow $ 65,000 104,000 112,800 157,280 185,280 218,640 189,000 168,000 84,000 28,000 20% Discount Factor 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 PV at 20% $54,145 72,176 65,311 75,809 74,483 73,244 52,731 39,144 16,296 4,536 $527,875 22% Discount Factor 0.820 0.672 0.551 0.451 0.370 0.303 0.249 0.204 0.167 0.137 PV at 22% $53,300 69,888 62,153 70,933 68,554 66,248 47,061 34,272 14,028 3,836 $490,273 $527,875 $490,273 $ 37,602

1 2 3 4 5 6 7 8 9 10 Total

PV of net cash inflows at 20%: PV of net cash inflows at 22%: Difference in PV with 2% difference in discount rate

Internal Rate of Return = 20% +

$27,875 2% = 21.48% $37,602

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20-31 Straightforward Capital Budgeting with Taxes (5 min) 1. Depreciation per year: ($30,600 - $600) ) 6 = $5,000 Taxable income Tax rate Income taxes $8,000 - $5,000 = x 3,000 40% $1,200

Net after-tax annual cash inflow: $8,000 - $1,200 = $6,800 2. Payback period: $30,600 ) $5,000 = 6.12 years 3. PV of annual savings PV of salvage value Total Initial investment NPV $5,000 x 4.623 = $23,115 $600 x .63 = 378 $23,493 30,600 <$7,107>

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20-32 Capital Budgeting with Tax and Sensitivity Analysis (10 min) Annual after-tax net cash inflow: Cash revenue Tax saving on depreciation expense Total
1.Payback period:

$1,200 x (1 - 0.35) = $600 x 0.35 = +

$780 210 $990

$6,000 = 6.06 years $990

2. Operating income in each of the 10 years: Sales Depreciation Operating income before taxes Taxes Operating income $1,200 600 $ 600 210 $ 390

Book rate of return =

3. 4. $990 x 5.019 = $4,969

$390 = 6.5% $6,000

Required net after-tax annual cash inflow: $6,000 ) 5.019 = Tax saving on depreciation expense Required net after-tax annual cash revenue 1 - tax rate Before-tax annual cash revenue needed ) $1,195 210 $985 0.65 $1,515

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20-33

Basic Capital Budgeting (5 min) 1. 2. 3. 4. $1,800 x 0.6 = $1,080 $12,500 x 0.6 x 3.17 = $23,775 $10,000 x 0.4 x 0.909 = $3,636 C

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20-34Equipment Replacement (20 min) 1. & 3. Discount Present Factor Value 0 AccuDril Operating Cost1 Overhaul cost Tax savings on depreciation2 Other Expenses3 Year 1 .893 <$90,193> Year 2 .797 <160,197> Year 3 .712 < 56,533> Year 4 .636 < 50,498> Year 5 .567 < 45,020> Total PV <$402,441> Buy RoboDril 1010K Equipment Purchase4 Operating Cost5 Tax saving on depreciation6 Other expenses7 Salvage value8 Total PV 1.000 3.605 3.605 3.605 .567 <$240,000> <86,520> 69,216 <118,965> 17,010 <$359,259>

PROBLEMS Cash Flows in 000 3 4 5 <48> <100> 4 <57> <201> <38.4> 16 <57> <79.4> <38.4> 16 <57>

2 <48> 4 <57> <101>

Overhaul <38.4> 16 <57>

<79.4>

<79.4>

<240>

<24>

<24>

<24> 19.2 <33>

<24>

<24> <33> <7.8>

19.2 19.2 19.2 <33> <33> <240> <37.8> <37.8>

19.2 <33> 30 <37.8> <37.8>

PV of the difference in cash flow between the alternatives RoboDril

$402,441 - $359,259 = $ 43,182 in favor of

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20-34 (Continued-1)
1

Years 1 and 2: $10 per hour x 8,000 hours x (1 - Tax Rate 40%) = $48,000 Years 3, 4, and 5: $48,000 x (1 - Improvement in efficiency 20%) = $38,400 Years 1 and 2: Depreciation expense per year: (Original Cost $120,000 - Salvage Value $20,000) 10 = $10,000 Tax Rate x 0.40 Tax savings on depreciation $ 4,000 Years 3, 4, and 5: Book value before overhaul Overhaul cost Total amount to be depreciated Number of years Depreciation expense per year Tax Rate Tax savings on depreciation $ 20,000 100,000 $120,000 3 $ 40,000 x 40% $ 16,000

$95,000 x (1 - Tax Rate 40%) = $57,000

Purchase price $250,000 Installation, testing, rearrangement, and training + 30,000 Subtotal $280,000 Trade-in allowance for AccuDril 40,000 Net purchase cost $240,000 5 $10 per hour x 4,000 hours x (1 - Tax Rate 40%) = $24,000
6

Depreciation expense per year Tax Rate Tax savings on depreciation

$240,000 5 Years =

$48,000 x 0.40 $19,200

$55,000 x (1 - Tax Rate 40%) = $33,000 $50,000 x (1 - Tax Rate 40%) = $30,000

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20-34 (Continued-2) 2. Year 0 1 2 3 Cash Flow AccuDril RoboDril $0 <$240,000> <$101,000> <201,000> <79,400> <37,800> <37,800> <37,800> Difference in Cash Flow <$240,000> 63,200 163,200 41,600 Cumulative Difference <$240,000> <176,800> < 13,600>

Payback period = 2 years +

$13,600 = 2.33 years $41,600

4. Among other factors that the firm should consider before the final decision are: Changes in technology for equipment Changes in market, especially demand for the product and competitors Reliability of the new machine and the expected effects of overhaul Reliability of AccuDril and accuracy of the estimates given Competitive strategy of the firm Differences in product qualities manufactured by the two machines

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20-35 Sensitivity Analysis (30 min) 1. Difference in PV between the two alternatives: PV discount factor for annuities from years 3 through 5: 2.402 x 0.797 = 1.914 or, 0.712 + 0.636 + 0.567 = 1.914 Additional annual after-tax savings needed from improvement in machine efficiency to make the overhaul of AccruDril a financially more attractive choice: $43,182

$43,182 = $22,561 1.914

Before-tax,

$22,56 1 = $37,602 0.6

$3 7 ,602 = 47% $80,000

For the replacement decision to be in error financially, the overhaul of AccuDril X10 needs to improve the operating efficiency by at least 53%.

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20-35 (Continued-1) 2. Overhaul in 2 years Tax savings from depreciation Overhaul cost

Discount Factor

Present Value

1 4

Cash Flows in '000 2 3 4 4 <100> <96> 16 16

5 16

PV of overhaul in 2 years

.893 .797 .712 .636 .567

3,572 <76,512> 11,392 10,176 9,072 <42,300> <80> <80,000> 30,005 2,869 2,848 2,544 2,268 <39,466> <80> 24

16

16

16

Overhaul now and again in 2 years Overhaul cost Savings from Improved efficiency1 Tax savings on depreciation2 1.000 .893 .797 .712 .636 .567

9.6

<30> 9.6 24 3.6

33.6

Difference in cost between the two alternatives: $42,300 - $39,466 = $2,834 It is better, financially, to overhaul now and again in 2 years.

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20-35 (Continued-2)
1

Savings from the improved productivity $10 per hour x 8,000 hours x 20% = Taxes on the saving Net after Tax savings $16,000 x 40% tax rate = $16,000 6,400 $9,600

Years 1 and 2: Book value at the time of overhaul: Overhaul cost Total amount to be depreciated Number of years Depreciation expense per year Tax Rate Tax savings on depreciation Years 3, 4, and 5: Overhaul cost Number of years Depreciation expense per year Tax Rate Tax savings on depreciation x $30,000 3 $10,000 0.40 $ 4,000 x $10,000 x 2 + $20,000 = + $ 40,000 80,000 $120,000 2 $60,000 0.40 $24,000

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 Cost of goods sold: Variable manufacturing costs $ 90 Fixed manufacturing costs: Additional fixed manufacturing overhead: $250,000 / 10,000 units = $25 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 $135 Number of units x 10,000 Total cost of goods sold 1,350,000 Gross margin $ 600,000 Marketing 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 $210,000 Add: Depreciation expenses included in fixed costs $20 x 10,000 = 200,000 200,000 Cash 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.

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20-36 (Continued-1) 3.

Payback Period =

$995,000 = 2.43 years $410,000

4. Average investment = ($995,000 + $195,000)/2 = $595,000 Average net income = $210,000 Book rate of return = $210,000 / $595,000 = 35.29 percent 5. PV of net cash inflows Year 1 through Year 3: $410,000 x 2.322 = $ Year 4: $605,000 x 0.592 = + Total present value net cash inflows $1,310,180 Initial investment NPV $ 6. PV of cash flows at 25%: $410,000 x 1.952 + $605,000 x 0.410 PV of cash flows at 30% $410,000 x 1.816 + $605,000 x 0.350 Changes in PV of cash flows 952,020 358,160 995,000 315,180

$1,048,370 $ 956,310 $ 92,060

Internal rate of return = 25% +

$1,0 48,370 - $995,000 5% = 27. 90% $92,060

7.a. The most decrease in after-tax net income per year without affecting the decision $315,180 / 2.914 = $108,161 Add: income taxes ($108,161 0.7) - $108,161 = + 46,354 The 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

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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 Proceeds from disposal Taxes on gains on disposal Cash outflow <$100,000> 2,400 <$97,600>

$3,000 < 600>

Year 1-4 Operating cost using the current machine ($40,000 + 10,000 + 10,000) x 0.8 = Operating cost using the SP1000 ($30,000 + 2,000 + 1,000) x 0.8 = Savings in operating cost with the new machine Savings in taxes on depreciation expense Depreciation expense $100,000 5 = $20,000 Tax rate x 20% Net cash inflows in each of Years 1-4 Year 5 After-tax cash inflow from savings in operating costs After-tax cash inflow from disposed of the investment $5,000 x 0.8 = Total cash inflow in year 5 2. PV of cash inflow in each of years 1-4: $25,600 x 3.465 = PV of cash inflow in year 5: $29,600 x 0.747 = Total PV of cash inflow Less: Initial investment NPV 3. Payback period = $97,600 $25,600 = 3.81 years

$48,000 26,400 $21,600 4,000 $25,600 $25,600 4,000 $29,600 $ 88,704 22,111 $110,815 < 97,600> $ 13,215

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20-37 (Continued-1) 4. The discount factor needed: $97,600 $25,000 = 3.904 Interest Rate Discount Factor 8% 8% 3.993 3.993 ? 3.904 9% 3.890 1% ? 0.103 0.089

Internal rate of return = 8% +

5. Cash Inflow $20,000 22,000 25,000 30,000 40,000 Interest Rate 10% 10% ? 12% 2% ? Discount factor at 10% 0.909 0.826 0.751 0.683 0.621 PV at 10% $ 18,180 18,172 18,775 20,490 24,840 $100,457

0.089 1% = 8.86% 0.103

Discount factor at 12% 0.893 0.797 0.712 0.636 0.567 PV at 12% $17,860 17,534 17,800 19,080 22,680 $94,954

Year 1 2 3 4 5

PV of Net cash inflows $100,457 $100,457 97,600 94,954 $5,503 $2,857

Internal rate of return = 10% +

$2,857 2% = 11.04% $5,503

6. Allowable after-tax increase in cost $13,215 4.212 = $3,137 1 - tax rate 0.8 Allowable cost increase before taxes $3,922 Number of units 10,000 Allowable 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
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min) After-tax net cash inflows Before Tax Cash Flow Depreciation Net Income Year Return Expense Income Tax (24%) 1 $ 9,000 $15,000 <$6,000> <$1,440> 2 3 4 5 12,000 15,000 9,000 8,000 $53,000 1. Year 0 1 2 3 4 5 12,000 9,000 6,000 3,000 $45,000 Cumulative After Tax Net cash inflow <$45,000> < 34,560> < 22,560> < < 9,000> 720> -06,000 3,000 5,000 -01,440 720 1,200 After Tax Cash Flow Return $10,440 12,000 13,560 8,280 6,800 $51,080

After Tax Cash Flow Return <$45,000> 10,440 12,000 13,560 8,280 6,800

Payback period = 4 years +

$720 = 4.11 years $6,800

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20-38 (Continued) 2. After Tax Cash Year Flow Return 1 $10,440 2 3 4 5 12,000 13,560 8,280 6,800 Discount Present Value of Cumulative Factor (10%) After Tax Net cash inflow .909 $ 9,490 .826 .751 .683 .621 9,912 10,184 5,655 4,223 $39,464 NPV = $39,464 - $45,000 = <$5,536> 3. Net Cash Year Inflow 1 $10,440 2 3 4 5 12,000 13,560 8,280 6,800 PV Factor At 6% 0.943 0.890 0.840 0.792 0.747 PV at 6% $ 9,845 10,680 11,390 6,558 5,080 $43,553 Discount Rate 4% 6% 2% ? 4% ? 43,553 $ 2,314 $ 867 PV of Net Cash Inflows $45,867 $45,867 45,000 PV Factor at 4% 0.962 0.925 0.889 0.855 0.822 PV at 4% $10,043 11,100 12,055 7,079 5,590 $45,867

Internal rate of return = 4% +

$867 2% = 4.75% $2,314

20-39Working Backward: Determine Initial Investment Based on Book Rate of Return (5 min)
Solutions manual 39

Let Y = Cost of the new machine Then,

($6,750

Y ) (1 0.20) 10 = 0.10 Y

($6,750 .1 Y) x 0.8 = 0.1Y Initial investment = $30,000

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20-40 Determine Initial Investment Based on Internal Rate of Return (5 min) Let C be the cost of the machine. Then, [$20,000 - ($20,000 - C/6) x 0.20] x 4.355 = C Cost of the machine, C = $81,513

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20-41 Determine Periodic Cash Flow Based on Book Rate of Return (5 min) Let Y be the firm's after-tax operating income

y = 0.15 $60,000

y = $9,000

Operating income before taxes = $9,000 ) (1 - 0.25) = $12,000 Total cash inflow before taxes:

$12 ,000 +

$60,000 = $24 ,000 5

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20-42 Machine Replacement and Sensitivity Analysis Without Taxes (10 min) Net additional cash outlay required for the new machine: $8,000 - $3,000 = 1.a. Payback period: $5,000/750 = 6.67 years b. Old Depreciation ($5,000 - $600)/11 = $400 Operating expense Difference in net income Book value: Year 0 Year 10 Average Investment (book Value) Old $5,000 - $400 = $4,600 600 $2,600 New $8,000 400 $4,200 New ($8,000 - $400)/10 = $760 Difference $360 <750> <$390> $5,000

Incremental average investment on new machine = $4,200 - $2,600 = $1,600

Accounting rate of return =

$390 = 24.3 8% $1,600

c. NPV = $750 x 5.650 ($8,000 - $3,000) - ($600 - $400) x 0.322 = $4,237.50 - $5,000 - $64.40 = <$826.90>

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20-42 (Continued) d. Present value of net cash inflows at 7%: $750 x 7.024 - $200 x 0.508 = Present value of net cash inflows at 8% %: $750 x 6.710 - $200 x 0.463 = 4,940 Difference Internal rate of return: $ 226 $5,166

7% +
2. 3.

166 1% = 7.73% 226

No. Because NPV < 0 (NPV is -$826.90) Let required saving = y. 5.650y - 200 x 0.322 = 5,000 5.65y = 5064.4 y = $896.35 Maximum required savings

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20-43

1.

Value of Accelerated Depreciation (5 min)

Year 1 2 3 4

PV Depreciation Method Difference Factor PV of SYD S-L Amount Tax Effect at 8% Tax Effect $40,000 $25,000 $15,000 $6,000 .926 $ 5,556 30,000 20,000 25,000 25,000 5,000 2,000 .857 .794 1,714 <1,588>

< 5,000> <2,000>

10,000 $100,000

25,000 <15,000> <6,000> $100,000

.735<4,410> $1,272

2. Year 1 2 3 4

PV Depreciation Method Difference Factor PV of DD S-L Amount Tax Effect at 8% Tax Effect $50,000 $25,000 $25,000 $10,000 .926 $9,260 25,000 12,500 12,500 $100,000 25,000 -0-0.857 .794 .735 -0< 3,970> <3,675> $1,615

25,000 <12,500> <5,000> 25,000 <12,500> $100,000 <5,000>

3. Year 1 2 3 4

PV Depreciation Method Difference Factor PV of DD S-L Amount Tax Effect at 8% Tax Effect $33,330 $25,000 $8,330 $3,332 .926 $3,085 44,450 14,810 7,410 $100,000 25,000 19,450 7,780 .857 6,667

25,000 <10,190> <4,076> 25,000 <17,590> $100,000 <7,036>

.794 < 3,236 > .735 <5,171 > $1,345

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20-44 Capital Budgeting with Sensitivity Analysis (15 min) 1. Expected annual net cash inflows ($600,000 + $100,000) Income taxes at 30% After-tax net cash inflows $700,000 210,000 $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 4.968 P = $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 + 0.05S S = $460,000 x 5.335 + 0.38S - 320,000 + 0.05S S = $2,454,100 + 0.43S - $320,000 0.57S = $2,134,100 S = $3,744,035 Year Depreciation 1 .2 P 2 .32 P 3 .192 P 4 .1152P 5 .1152P 6 .0576P Tax Effect .06 P .096 P .0576 P .03456P .03456P .01728P PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 Present Value .05358 P .076512 P .0410112P .0219801P .0195955P .0087609P .2214397P

3.

P = $2,434,320 + .2214397P .7785603P = $2,434,320 P = $3,126,694

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20-45Cash Flow Analysis and NPV (15 min) PV CASH FLOWS IN YEAR (in '000) Item & Description Factor PV 0 1 a. Foregone rent ($5,000 x 12 x 0.6) b. All are irrelevant c. Remodeling Depreciation 3.433 0.877 0.769 0.675 0.592 0.519 <$123,588> < 100,000> 14,032 7,382 3,888 2,557 2,242 <100> <36> 16

2 <36>

3 <36>

<36> <36>

9.6

5.76

4.32

4.32

d. Investment in inventory and receivables < 600,000> Recovery 0.519 311,400 e. Irrelevant f. Sales ($900 x 0.6) 3.433 1,853,820 Operating expenses ($500 x 0.6) 3.433 <1,029,900> g. Sales Promotion ($100 x 0.6) < 60,000> h. Termination ($50 x 0.6) 0.519 < 15,570> NPV $ 266,263

<600> 540 < 60> <300> 540 <300> 540 <300> 540

600 540

<300> <300> < 30>

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.

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20-46 Machine Replacement with Tax Considerations (15 min) Present Value of Costs with the Original Equipment Present value of tax savings on depreciation: $2,500,000 4 x 0.45 x 2.577 = Present value of operating costs: $1,800,000 x (1 - 0.45) x 2.577 = Present value of salvage value: $50,000 x (1 - 0.45) x 0.794 = Present value of costs with the original equipment Present value of the costs with the new machine Initial outlay <$2,000,000> Present value of tax savings on depreciation: Beginning Depreciation Tax Tax Discount Year Book Value Expense Rate Saving Factor 1 $2,000,000 $1,333,333 x 0.45 = $600,000 x 0.926 2 666,667 444,445 x 0.45 = 200,000 x 0.857 3 222,223 222,223 x 0.45 = 100,000 x 0.794 Cash proceeds from sale of the old machine Tax saving of loss on disposal of the old machine ($1,875,000 - $300,000) x 0.45 = Present value of operating costs $1,000,000 x (1 - .45) x 2.577 = Total cost at present value 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. Present Value = $ 555,600 = 171,400 = 79,400 300,000 708,750 <1,417,350> <$1,602,200>

$724,781 <2,551,230> 21,835 <$1,804,614>

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20-47 Equipment Replacement (15 min) 1.a. Selling price Variables cost: Direct materials Direct labor Indirect costs Contribution margin per unit $30.00 $0.25 x 8 = $8.00 x 2 = $2.00 16.00 0.30

b.

18.30 $11.70

$0.3 +

$25,000 = $0.55 100,000

$25,000 7,000 $32,000

c. Current fixed costs Increase in equipment depreciation: New equipment ($100,000 - $10,000) 10 = $9,000 Current 2,000 Total fixed costs d.

Total overhead = $32,000 + $0.40 per unit x Units manufactured

$32,000 + $0.4 0 = $0.72 100,000

e. Selling price Variables cost: Direct materials Direct labor ($8 per hour x 1 hour) Indirect costs Contribution margin per unit $30.00 $2.00 8.00 0.40

10.40 $19.60

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20-47 (Continued) f. Purchase price Proceeds from selling the old saw Tax savings from loss on disposal: Book value $20,000 Selling price 4,000 Loss on sales $16,000 Tax rate 0.40 Net additional investment required $4,000 $100,000

6,400

10,400 $89,600

g. Increase in contribution margin per unit $19.60 - 11.70 = $ 7.90 Number of units x 100,000 Increase in total contribution margin before taxes $790,000 Increase in income taxes ($790,000 x 40%) - 316,000 Increase in total contribution margin after taxes $474,000 Additional tax savings from depreciation $7,000 x 0.4 = 2,800 Expected 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 Current manufacturing cost Current contribution margin per unit Additional saving with the new machine Contribution margin per unit of the additional units Net cash inflows: Present Discount Value Factor 2007 <$608,000> <12,000> $3,500 - 2,450 $1,050 + 150 $1,200

Item Description Purchase cost Installation Net proceeds from disposing old 30,000 Contribution margin Per unit Additional units CM from additional units (000) Efficiency saving (000) Total increase in CM before taxes (000) Income taxes (000) Total after tax increase In CM before depreciation (000) After tax proceeds from disposal ($80,000 x .6) Tax saving from depreciation (000) Total net cash inflow 153,815 165,392 94,996 105,300 Net Present Value <$70,497>

2008

2009

2010

$1,200 $1,200 $1,200 $1,200 30 50 50 70 $ 36 125 $161 64.4 $96.60 $ 60 125 $185 74 $111 $ 60 125 $185 74 $ 84 125 $209 83.6

$111 $125.4 48

81.84 111.60 37.20 17.36 .862 $178.44 .743 222.60 .641 148.20 .552 190.76

VacuTech can expect to have a negative net present value of $70,497 if it purchases the new pump.

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20.48 (Continued) 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 NPV $ 3,000,000 18,240

Yes. The group can expect a positive NPV of $18,240.

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20-50 Risk and NPV (5 min) 1. PV at 12%: $275,000 x 6.194 = $1,703,350 Yes, because $1,703,350 > $1,500,000 2. PV at 16%: $275,000 x 5.197 = $1,429,175 No, because $1,429,175 < $1,500,000 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: 12 years : $600,000 x 6.142 = $3,685,200 Yes $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 at least a 14% return is approximately 13 years.

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20-52 Uneven Cash Flows (5 min) Present value of net cash inflows: Year 2 Year 3 Year 4 Years 5-10 Initial investment NPV $1,000,000 x .797 = $1,000,000 x .712 = $2,500,000 x .636 = $3,000,000 x 4.111 x .567 = $ 797,000 712,000 1,590,000 6,992,811 $10,091,811 15,000,000 $<4,908,189>

Total present value of net cash inflows

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20-53 Environment Cost Management (20 min) 1.

Solvent System Present Value $400,000 Year 1 $228,000 40,000 16,000 212,000 0.893 189,316 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Ye

Initial investment After-tax Operating cost Depreciation Tax saving on depreciation Net after-tax cost Discount factor (12%) Present value Total cost Powder System Initial investment After-tax Operating cost Depreciation Tax saving on depreciation Net after-tax cost Discount factor (12%) PV Total cost Difference in total cost

$228,000 $228,000 $228,000 $228,000 $228,000 $228,000 $22 72,000 57,600 46,080 36,880 29,480 26,200 2 28,800 23,040 18,432 14,752 11,792 10,480 1 199,200 0.797 158,762 204,960 0.712 145,932 209,568 0.636 133,285 213,248 0.567 120,912 216,208 0.507 109,617 217,520 0.452 98,319

21

1,191,075 $1,591,075

$1,200,000 $240,000 120,000 48,000 192,000 0.893 171,456

$240,000 $240,000 $240,000 $240,000 $240,000 $240,000 $24 216,000 172,800 138,240 110,640 88,440 78,600 7 86,400 69,120 55,296 44,256 35,376 31,440 3 153,600 0.797 122,419 170,880 0.712 121,667 184,704 0.636 117,472 195,744 0.567 110,987 204,624 0.507 103,744 208,560 0.452 94,269

20

1,064,182 $2,264,182 $673,107

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20-53 (Continued) 2. Monthly pit cleaning Hazardous waste disposal Superfund fee Worker training Insurance Amortization of air-emission permit Air-emission fee Record keeping Wastewater treatment Total annual environment cost Tax saving Net after-tax environment cost Annuity factor (12%, 10 years) PV of environment cost Total saving in investment and operating cost Present value of the increase in total cost Units 12 183 18,690 2 1 0.2 44.6 0.25 1 Unit Cost Total ost 1,000 $ 12,000 3,000 549,000 0.17 3,177 1,500 3,000 10,000 10,000 1,000 200 25 45,000 50,000 1,115 11,250 50,000 $639,742 255,897 $383,845 5.650 $2,168,724 673,107 $1,495,617

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