Chapter 12

Strategic Investment Decisions

LEARNING OBJECTIVES
Chapter 12 addresses the following questions:
Q1
Q2
Q3
Q4
Q5

How are strategic investment decisions made?

What cash flows are relevant for strategic investment decisions?
How is net present value (NPV) analysis performed and interpreted?
What are the uncertainties and limitations of NPV analysis?
What alternative methods (IRR, payback, and accrual accounting rate of return) are used
for strategic investment decisions?
Q6 What additional issues should be considered for strategic investment decisions?
Q7 How do income taxes affect strategic investment decision cash flows?
Q8 How are the real and nominal methods used to address inflation in an NPV analysis?
(Appendix 12A)
These learning questions (Q1 through Q8) are cross-referenced in the textbook to individual
exercises and problems.

COMPLEXITY SYMBOLS
The textbook uses a coding system to identify the complexity of individual requirements in the
exercises and problems.
Questions Having a Single Correct Answer:
No Symbol
This question requires students to recall or apply knowledge as shown in the
textbook.
This question requires students to extend knowledge beyond the applications
e
shown in the textbook.
Open-ended questions are coded according to the skills described in Steps for Better Thinking
(Exhibit 1.10):

Step 1 skills (Identifying)

Step 2 skills (Exploring)

Step 3 skills (Prioritizing)

Step 4 skills (Envisioning)

12-2 Cost Management

QUESTIONS
12.1

After a number of years, the present value factors for all discount rates become quite
small, and the incremental affect of future cash flows is therefore small. According to the
present value tables, after about 15 years, the incremental values at rates above 8 to 10%
are small (less than 20% of the original value). If these cash flows are small, but include
error, the size of error would also be small and likely have little effect on the overall
analysis.

12.2

If several projects are being analyzed, their NPVs can be summed to determine the NPV
for that group or portfolio of projects, whereas IRR can be neither summed nor averaged.
In addition, NPV provides information about the value of the projects in terms of todays
dollars. If projects are of different sizes, requiring large and small investments, NPV
reflects these differences. IRR provides only a rate of return, and comparing rates of
return does not take into consideration the size of return. In addition, the net present
value method is computationally simpler than the internal rate of return method.
Determining IRR can be time consuming, particularly for projects having uneven cash
flows. However, the use of a spreadsheet reduces the effort considerably.
An important difference between the two methods is that the IRR method assumes cash
inflows can be reinvested to earn the same return that the project would generate.
However, it may be difficult for an organization to identify other opportunities that could
achieve the same rate when IRR is high. In contrast, the NPV method assumes that cash
inflows can be reinvested and earn the discount ratea more realistic assumption. If the
discount rate is set equal to the organizations cost of capital, then alternative uses of cash
would include paying off creditors or buying back stock. Therefore, if the results of
analyses using the two methods are not the same, the NPV method is preferable.
Both methods are used widely in business. One reason for the continued use of IRR is
that many people find it intuitively easier to understand than NPV. In addition, managers
may want to compare the IRR on prior projects to current project return rates as they
consider new investment.

12.3
(a) Net present value (NPV)
Pros:
NPV is more accurate than the payback and accrual accounting rate of return
methods because it reflects the time value of money.
Under NPV, discounted cash flows reflect todays dollars, so several different
projects can be easily compared to determine the one with the highest NPV.
Cons:
It is sometimes more difficult to estimate cash flows and choose an
appropriate discount rate for NPV than finding the internal rate of return or
calculating payback or an accounting rate of return.

Chapter 12: Strategic Investment Decisions 12-3

(b) Internal Rate of Return (IRR)
Pros:
Many managers find IRR intuitively easier to understand than NPV
IRR has the same advantage as NPV of including the time value of money.
IRR can be used to compare potential projects (choose the one with highest
IRR).
Cons:
Assumes cash flows can be reinvested at the IRR
When comparing projects, IRR does not take into consideration size of
investment and may be inappropriate when managers need to choose among
competing projects because capital is constrained.
IRRs from several projects cannot be summed or averaged, while net present
values can.
IRR is computationally more difficult than NPV and the other methods,
particularly with uneven cash flows.
(c) Payback Method
Pros:
Used extensively, particularly outside of the U.S.
Focuses on high risk of long payback period
Cons:
Does not incorporate time value of money
Ignores cash flows received after the investment is recovered
(d) Accrual Accounting Rate of Return
Pros:
Use for division or department performance because data is readily available
Cons
Cost of investment is double-counted (depreciation is included in the
numerator, and the investment is the denominator)
Not appropriate for capital budget decisions because it does not include the
time value of money
12.4

Estimating future cash flows becomes more difficult over longer periods of time because
the uncertainties increase. Changes in economic, political, and consumer tastes that
affect cash flows cannot be easily predicted. More information is usually available about
near-term economic factors than long-term.

12.5

Future cash flows are discounted with present value factors that become increasingly
small across time to reflect the fact that investors forego interest on cash flows that are
received in the future relative to cash flows that are received today and could be invested
today. This discounting reflects the opportunity cost (interest foregone) when money is
received in the future instead of today.

12-4 Cost Management

12.6

A nominal discount rate includes a factor for inflation, and the real rate does not. Both
rates include a risk-free rate and a risk premium. Using a nominal approach, different
cash flows can be inflated differentially. For example, gasoline prices might inflate at a
different rate than wages. If different types of cash flows are differentially inflated to
better reflect future expectations, the preciseness of the estimation and analysis process
increases and information quality increases.

12.7

Real assets tend to increase in nominal value under inflation, while monetary assets tend
to remain fixed. If a firm has cash in a bank earning interest, the after-tax return could be
less than the inflation rate. Therefore the firms cash would be losing purchasing power
over time. In this case it would be better for the firm to invest in a real asset that
increases at the inflation rate or greater.

12.8

Net present value. All investments with a positive net present value would be accepted,
assuming that the cost of capital is constant across investments.

12.9

Requiring a higher return rate for projects in developing countries may be the firm's way
of coping with increased problems of uncertainty and risk. Less developed countries
usually have less stable political systems, economies, inflation rates, and consumer
markets. In addition, infrastructure such as roads and utilities is sometimes unreliable, so
production and transportation problems could occur more frequently. These factors
increase the risk of doing business in developing countries.
From the host government's point of view, if a higher rate of return is not permitted under
such circumstances, the investment would probably never have been made at all, and the
developing country would be worse off as a result. The firm, however, must be careful to
avoid any perception of exploitation, as the long-term reputation effect could be
devastating.

12.10 There are two reasons to incorporate tax effects more formally into NPV analyses. From
an accounting standpoint, tax regulations permit a shift of both the amount and the timing
(sometimes permanently) of taxes; this will have an effect on present values. If tax
savings based on current tax rules are not incorporated into the analysis, these effects are
not captured and the analysis is less accurate. From a mathematical standpoint, the
factors in the tables are not linearly related (all of the formulas have exponents); e.g., the
present value factor for 20% is not one-half of the factor for 10%.
12.11 The return on the investment portfolio represents the clinic's opportunity cost for funds.
They can earn at least that return; therefore, any other investment must yield a higher
return.

Chapter 12: Strategic Investment Decisions 12-5

EXERCISES
12.12 Time Value of Money
A. Using tables, the answer is ($8,000 x 0.583) = $4,664.
Using Excel, the answer is $4,667.92.
B. Using the tables, the answer is ($125 x 1.791) = $223.88.
Using Excel, the answer is $223.86.
C. Using tables, the answer is ($10,000 x 0.747) = $7,470.
Using Excel, the answer is $7,472.58.
D. Using tables, the answer is ($1,000 x 0.507) = $507.
Using Excel, the answer is $506.63.
12.13 Capital Budgeting Process
The proper sequence is: 4, 1, 5, 2, 3, and 6.
12.14 Overnight Laundry
Cash Flow Timeline:
Investment
Incremental cash flows:
Annual Savings
Taxes
Net cash flow
Terminal value

Time 0
$(96,000)

Years1-10

Year 10

$25,000
(5,128) (a)
$19,872
$6,000

(a) The salvage value is ignored for income tax depreciation, so the annual
depreciation = $96,000/10 years = $9,600 per year
Taxes per year = ($25,000 - $9,600) * 33.3% = $5,128
NPV calculation:
NPV = $(96,000) + $19,872 (PVFA 18%, 10 years) + $6,000 (PVF 18%, 10 years)
= $(96,000) + ($19,872 x 4.494) + ($6,000 x0.191)
= $(96,000) + $89,305 + $1,146
= ($5,549)

12-6 Cost Management

12.15 Axel Corporaton
The net present value is $30,000 (5.019) - 150,000 = $570.
The internal rate of return is a little higher than 15%. Using Excel, the actual rate is
15.098%.
12.16 Amaro Hospital
A. The net present value is ($5,000 x 5.216) - 20,000 = $6,080
B. The factor for the internal rate of return must be
20,000 = $5,000*Factor
Factor = 4.0
From the PVFA tables for 10 year, it would be just over 20% (PVFA = 4.192)
Using Excels IRR function, the rate is 21.4%
C. Assuming straight-line depreciation, the earnings will be
$5,000 - $20,000/10 = $3,000
The accounting rate of return is $3,000/20,000 = 15%
D. The payback period is $20,000/$5,000 = 4
12.17 Crown Corporation
A. The PVFA for four payments discounted at 6% is 3.465. Thus, the present value of the
note is $1,000 x 3.465 = $3,465. With the down payment, the total is $4,465.
B. Because this is a single payment the factor is a present value single amount of 0.735, so
the total is $4,000 x .735 = $2,940. With the down payment it becomes a total present
value selling price of $3,940.
C. The selling price of the equipment is $5,000 no matter how the employee gets the cash
and what Crown does with the $5,000. The future value factor for three years hence is
1.225, yielding: $5,000 x 1.225 = $6,125.

Chapter 12: Strategic Investment Decisions 12-7

12.18 Clearwater Bottling Company
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at www.wiley.com/college/eldenburg).
A.
Cash Flow Timeline:
Investment
Incremental cash flows:
Annual Savings
Taxes
Net cash flow
Terminal value

Time 0
$(100,000)

Years1-5

Year 10

$20,000 (a)
(0) (b)
$20,000
$0

(a) Savings = Additional contribution margin Increase in fixed costs

= ($9 - $7) x 20,000 cases - $20,000 = $20,000
(b) Depreciation = $100,000/5 years = $20,000 per year
Incremental Taxes = (Savings Depreciation) * 25%
= ($20,000 - $20,000) * 25% = $0
B. The NPV for this part can easily be calculated manually as shown below. The sample
spreadsheet shows the NPV to be $(27,904). The difference is due to rounding.
NPV = $(100,000) + $20,000 (PVFA 12%, 5 years)
NPV = $(100,000) + $20,000 x 3.605
NPV = $(27,900)
C. To determine the amount of sales needed to bring the NPV to zero, first re-write the
incremental cash flows substituting Q for the volume of cases sold.
Cash Flow Timeline:
Time 0
$(100,000)

Investment
Incremental cash flows:
Annual contribution margin
Incremental fixed costs
Incremental taxes
Net cash flow
Terminal value

Years1-5

Year 10

$2Q (a)
(20,000)
($0.5Q - $5,000) (b)
$1.5Q - $15,000

(a) Annual contribution margin per case (Q) = ($9 - $7)Q = $2Q
(b) Depreciation = $100,000/5 years = $20,000 per year
Incremental Taxes = ($2Q $20,000) * 25%
= $0.5Q - $5,000

$0

12-8 Cost Management

Next, set the NPV equal to zero and solve for Q:
0 = $(100,000) + ($1.5Q - $5,000) x 3.605
= = $(100,000) + 5.4075Q - $18,025
5.4075Q = $118,025
Q = 21,826 cases
D. Below is an excerpt from the sample spreadsheet showing calculations using the nominal
method:

Chapter 12: Strategic Investment Decisions 12-9

Below is an excerpt from the sample spreadsheet showing calculations using the real
method:

12.19 Parish County

This problem is most easily solved in steps. First determine the present value of the
terminal cash flow:
Terminal value = $400,000 x 20% = $80,000
Present value = $80,000 x (PVF, 10%, 5 years) = $80,000 x 0.621 = $49,680
Subtract the present value of the terminal value from the investment to determine the
present value needed from annual savings to justify the purchase:
Minimum PV of annual savings = $400,000 - $49,680 = $350,320

12-10 Cost Management

Finally, determine the annual savings needed to achieve the present value calculated
above. The following calculation assumes that the annual savings would be identical
during each of the 5 years.
Savings x (PVFA, 10%, 5 years) = $350,320
Savings x 3.791 = $350,320
Savings = $350,320/3.791 = $92,408
The company must generate at least $92,408 per year in savings to justify purchasing the
plane.
12.20 Equipment Investment
A.
Time 0 investment = -$60,000
Years 1-6:
Annual saving
Depreciation
Total annual after-tax flows

Year
1
2
$18,000 $18,000
4,000
4,000
$22,000 $22,000

3
4
5
6
$18,000 $18,000 $18,000 $18,000
4,000
4,000
4,000
4,000
$22,000 $22,000 $22,000 $22,000

Calculation details:
Annual after-tax savings = $30,000 * (1-0.40) = $18,000
Straight-line depreciation = $60,000/6 years = $10,000 per year
Depreciation tax savings per year = $10,000 * 0.40 = $4,000
NPV calculation:
NPV = -$60,000 + $22,000 x (PVFA 10% 6 years)
NPV = -$60,000 + $22,000 x 4.355 = $35,810
C. To determine the payback period, first summarize the cumulative cash flows from the
project:
Year
1
2
3

Cumulative Cash Inflows

22,000
44,000
66,000

The original investment is $60,000, which is expected to be paid back between 2 and 3
years. If the cash flows are assumed to occur evenly throughout each year, the payback
period is 2.73 years [(2 + (60,000 - 44,000)/22,000)]. Because cash flows are identical
across years, the payback can also be calculated as follows: $60,000/$22,000 = 2.73
years.

Chapter 12: Strategic Investment Decisions 12-11

12.21 Ferris Industries
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at www.wiley.com/college/eldenburg).
A. Internal rates of return were calculated using the Excel function IRR. The rates of return
are
Project
IRR
1
15.67%
2
27.32%
3
26.59%
4
28.14%
Based solely on the internal rate of return, the projects would be ranked 4, 2, 3, and 1.
B. There appear to be considerable differences in risk among the projects. Projects 2 and 3
expect negative incremental operating cash flows during some of the years, and project 4
expects zero incremental operating cash flows during 2 of the 6 years. Projects 2, 3, and
4 show more variation across years than project 1. If there is a high rate of technological
change in this industry, management may prefer project 2, which pays back most of the
investment quickly.
12.22 Lymbo Company, Inc.
A. Based on the NPV of the two alternatives, the company should choose Alternative 2 with
a less negative NPV than Alternative 1. Calculations for each alternative are shown
below.
Cash Flow Timeline for Alternative 1:
Time 0
Investment
$(100,000)
Incremental cash flows:
Maintenance Cost
Taxes
Net cash flow

Years 1-5
$(20,000)
12,000 (a)
$ (8,000)

Years 6-15
$(20,000)
6,000 (b)
$(14,000)

(a) Depreciation = $100,000/5 years = $20,000 per year

Incremental taxes deductions during years 1-5 = (Maintenance cost +
Depreciation) * 30%
= ($20,000 + $20,000) * 30% = $12,000
(b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%
= $20,000 * 30% = $6,000

12-12 Cost Management

NPV Calculation for Alternative 1:
NPV = $(100,000) + [$(8,000) x (PVFA 12%, 5 years)] + [$(14,000) x (PVFA
12% 15 years PVFA 12% 5 years)]
NPV = $(100,000) + [$(8,000) x 3.605] + [$(14,000) x (6.811 3.605]
NPV = $(100,000) + $(28,840) + $(44,884) = $(173,724)
Following is a different way to perform the same calculations for Alternative 1:
NPV of installation cost
NPV of annual maintenance cost
$(20,000) x (1-30%) x 6.811
NPV of depreciation tax shield
$20,000 x 30% x 3.605
Total NPV

$(100,000)
(95,354)
21,630
$(173,724)

Cash Flow Timeline for Alternative 2:

Investment
Incremental cash flows:
Maintenance Cost
Taxes
Net cash flow

Time 0
$(150,000)

Years 1-5
$(10,000)
12,000 (a)
$ 2,000

Years 6-15
$(10,000)
3,000 (b)
$ (7,000)

(a) Depreciation = $150,000/5 years = $30,000 per year

Incremental taxes deductions during years 1-5 = (Maintenance cost +
Depreciation) * 30%
= ($10,000 + $30,000) * 30% = $12,000
(b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%
= $10,000 * 30% = $3,000
NPV Calculation for Alternative 2:
NPV = $(150,000) +[ $2,000 x (PVFA 12%, 5 years)] + [$(7,000) x (PVFA 12%
15 years PVFA 12% 5 years)]
NPV = $(150,000) + [$2,000 x 3.605] + [$(7,000) x (6.811 3.605)]
NPV = $(150,000) + $7,210 + $(22,442) = $(165,232)
Following is a different way to perform the same calculations for Alternative 2:
NPV of installation cost
NPV of annual maintenance cost
$(10,000) x (1-30%) x 6.811
NPV of depreciation tax shield
$30,000 x 30% x 3.605
Total NPV

$(150,000)
(47,677)
32,445
$(165,232)

Chapter 12: Strategic Investment Decisions 12-13

B. Following are the NPV calculations without the depreciation tax shield:
NPV without income taxes for Alternative 1:
NPV of installation cost
NPV of annual maintenance cost
$(20,000) x 6.811
Total NPV

$(100,000)
(136,220)
$(236,220)

NPV without income taxes for Alternative 2:

NPV of installation cost
NPV of annual maintenance cost
$(10,000) x 6.811
Total NPV

$(150,000)
(68,110)
$(218,110)

The answer depends on management's time-frame used in the budget process. If the notfor-profit organization intends to occupy the building for the next 15 years, alternative 2
is still the best choice. However, management may concern itself only with current year
outlays (a focus of many governmental units). In that case, alternative 1 might be chosen
because its initial cost is $50,000 less than alternative 2's. Although this is a common
approach, one might question whether it is "proper."
12.23 Garco
A.
Initial net investment (1,000,000 - 60,000)
Annual savings 300,000
Net present value

Present Value
Factor
1.00
3.605

Present
Value
$ (940,000)
1,081,500
$ 141,500

B. First calculate the present value factor for an annuity of 5 payments that equates the cash
inflows and outflows:
$300,000 * F = 940,000
F = 3.13333
A factor of 3.13333 represents an internal rate of return of slightly less than 18%.
A spreadsheet could be used to determine the exact answer of 17.913%.
C. Assuming the cash flows take place evenly throughout the year:
$940,000/$300,000 = 3.13 years

12-14 Cost Management

PROBLEMS
12.24 Jackson
[Note about problem complexity: Item B is not coded as Step 3 because this is explicitly
discussed in the chapter.]
A. The choices are (1) hold the stock and work for $90,000 per year or (2) sell the stock, do
not take the job, and start the restaurant. This is a long-term decision.
B. Either IRR or NPV methods could be used for this analysis. The decision is a long-term
decision and therefore needs to include the time value of money. Both of these methods
do that. With the NPV method, inflation rates for different categories of costs could be
used, so the results would be more precise. In addition, it may be easier to understand the
differences in these two plans in todays dollars, rather than in rates of returns.
C. His opportunity costs are $90,000 plus benefits from the job offer, plus the return on the
stock.
D. The following categories would be set into an input box: Investment amount, risk free
rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates,
all of the cash flows from the restaurant (revenues and variable and fixed costs). Once
these are in the input box, formulas for calculating the incremental cash flows over time
need to be set up, and the real cash flows would need to be inflated and then discounted.
If depreciation is relevant for the investment, a MACRS table would need to be added.
E. Uncertainties about a new job include lack of information about the people Jackson
would work with, and also about the nature of the work to be done. The future of the
company is not guaranteed. Students may have thought of other uncertainties.
F. Jackson faces uncertainties about customer preferences, which will result in uncertainty
about revenues. He has not operated a restaurant, so he faces uncertainties about current
costs and cost trends over time. He also faces uncertainties about the quality and quantity
of employees available to cook, wait tables, and perform other tasks that need to be done.
G. Jackson faces many uncertainties, no matter which alternative he chooses. If he performs
sensitivity analyses around each alternative and formally incorporates qualitative factors,
such as the amount of enjoyment he takes in his current position and his perceptions of
this aspect of owning a restaurant, he will be able to make a high quality decision.

Chapter 12: Strategic Investment Decisions 12-15

12.25 Homeless Shelter
[Notes about problem complexity: Part A is not coded as Step 2 because the advantages and
disadvantages are explicitly presented in the text. Part C will be quite difficult for most
students.]
A. Advantages of IRR

Disadvantages

investment.

It is easy to explain
It can be calculated using a spreadsheet

Without spreadsheets, it is time consuming to calculate

It does not take into consideration the relative size of projects
It does not give information about the dollar value of the

B. The discount rate should be different for every project because the risk of every project is
different. Part of the discount rate is the risk premium, and that should be higher for
projects that are riskier.
C. For discount rates, the following information would be helpful: current and historical
inflation rates and T-bill rates. In addition, historical financial information about the
three alternative projects or similar projects in similar would be important to develop the
risk premium. Information about demand for rooms, apartments, and boxes would be
needed. Information about the availability of management and employees for the three
alternatives would be useful.
D. The answer to this question depends in part upon the assumptions made about the current
operations of the homeless shelter. If the shelters current operations are similar to an
apartment complex, the second alternative is probably least risky because of the rent
subsidization, the first alternative next most risky, and the manufacturing operation most
risky. Information about demand and employee stability is likely to be more uncertain
than information about occupancy rates, etc. However, if the homeless shelter is just a
large space with cots for homeless people, the managers experience may be irrelevant
when considering risk.
The amount of financial risk also depends on the size of investment. The managers need
to consider potential problems that could affect financial outcomes. A hotel that offers
rooms based on ability to pay could attract people who are using the hotel for illegal
activities and require a great deal of monitoring. Alternatively, the manufacturing
operation requires managers who are trained to work with homeless people and skilled at
managing manufacturing operations. To better understand the financial risks for the three
different types of operations, the managers may want to find similar businesses in the
local area and examine their revenues and expenses across time. Managers of not-forprofit organizations are often willing to share information with each other.

12-16 Cost Management

12.26 Real Interest Rates
A. The real rate includes both a risk free rate and a risk premium.
B. The risk free rate is affected by decisions by the Federal Reserve about the prime rate,
and economic growth rates. The level of uncertainty and potential volatility of the cash
flows for the project affect the risk premium.
C. Interest rates vary a great deal across time. They are affected by government policy,
inflation, stock market returns, and many other factors that are difficult to predict.
D. Yes, the length of the project can make a difference in the certainty of the chosen rate.
Interest and inflation rates usually trend across time; they move slowly up or down. If
the project has a short life (3-5 years) and rates are currently low (or high), managers
would expect them to rise ( or decrease), but slowly. The choice of discount rate is less
certain for projects with long lives (15-20 years or more). Interest and inflation rates
could vary a great deal over this length of time, and predicting the average rate for the
entire time period involves more uncertainty.
12.27 Green Jade Resorts
A.
Net Present Value (NPV): The sum of todays and future cash flows discounted to todays
dollars
Internal Rate of Return (IRR): Discount rate necessary for the present value of the
discounted cash flows to be equal to the investment
Payback Method: Measures the amount of time required to recover the initial investment
Accrual Accounting Rate of Return: Expected increase in average annual operating
income as a percent of the initial increase in required investment
B.
Net Present Value (NPV)
Pros
Incorporates the time value of money
Calculates the discounted cash flows discounted in todays dollars
If multiple projects are being considered, it is easier to identify the most
profitable projects
Cons
Requires estimating cash flows and choosing an appropriate discount rate

Chapter 12: Strategic Investment Decisions 12-17

Internal Rate of Return (IRR)
Pros
Intuitively easier to understand for many managers
Can be used to compare potential projects to other ones
Cons
Computationally more difficult, particularly with uneven cash flows
Cannot sum or average IRR for multiple projects
Assumes cash flows can be reinvested at the IRR
Payback Method
Pros
Focuses on high risk of long payback period
Used extensively, particularly outside of the U.S.
Cons
Does not incorporate time value of money
Ignores cash flows received after the investment is recovered
Accrual Accounting Rate of Return
Pros
Use for division or department performance because data is readily available
Cons
Does not incorporate time value of money
Cost of investment is double-counted
Not appropriate for capital budget decisions
C. Price changes and consumer preferences cannot be easily predicted across time. This
type of business is greatly affected by changes in economic conditions. When the
economy is strong, people have more money for vacation travel, but it is a discretionary
cost that is cut during economic downturns. In addition, consumer preferences change
over time, and are affected by competing resort availability. These factors decrease the
accuracy of any predictions made.
D. The NPV method and NPV profitability index would be the best quantitative methods for
this decision. Using these methods inflation rates can be altered to more accurately
reflect differences in inflation rates in the three different locations. Further, it is difficult
to compare rates of return under the IRR method and the payback and accounting rate of
return methods do not incorporate the time value of money.
E. The managers may respond unfavorably to methods with which they are unfamiliar.
Therefore, it is important to make an educational presentation that simply explains the
recommended method and that emphasizes its benefits.

12-18 Cost Management

F. There are many different types of memos that can be written. At a minimum, the memo
should briefly describe the pros and cons of their current method (payback) and of a
preferred alternative. The memo should be written in non-technical language that
managers can easily understand, and it should also address the managers concerns about
changing methods.
12.28 Irrigation Supply
A.
Cash Flow Timeline:
Investment
Incremental cash flows:
Operating income
Taxes
Net cash flow
Terminal value

Time 0
$(20,000)

Years1-5

Year 5

$6,000 (a)
(500) (b)
$5,500
$0

(a) $18,000 - $12,000

(b) Taxes = net savings less depreciation times tax rate = [$6,000
($20,000/5)]*25%
B. NPV calculation:
NPV = -$20,000 + $5,500 x (PVFA 16%, 5 years)
NPV = -$20,000 + $5,500 x 3.274
NPV = -$1,993
C. Payback = $20,000/$5,500 = 3.64 years
D. The results of the NPV analysis indicate that, after 5 years, Irrigation Supply will have
lost $1,993 in todays dollars. This means that the investment will not have paid for itself
in 5 years. Results from the payback method indicate that the investment will be
recovered in 3.33 years. The payback period is shorter than 5 years because the time
value of money and income taxes are not taken into consideration.
E. A number of different factors affect prices and demand. If competitors prices decrease,
the hardware store may not be able to pay the current price. New technology could make
the sprinkler heads obsolete. Weather patterns could change and alter demand. Land use
could change, altering demand. These are just a few examples, students may think of
others.
F. If Irrigation Supply relies on the hardware store for a portion of the contribution margin,
any changes experienced by the hardware store will have an affect on Irrigation Supply.
If the portion is small, the effect will be small, and if it is large, the effect could be quite
large.

Chapter 12: Strategic Investment Decisions 12-19

12.29 Carbondale Architectural Design Group
A. Data for this problem is summarized as follows:
Investment
$110,000
Annual Annuity
$36,000
Period
5 years
Discount rate
18%
Terminal value
$0
Annual depreciation
$22,000
Tax rate
25%
Taxes
$3,500
After Tax CF
$32,500
NPV calculation:
PV of CF ($32,500 x 3.127 - PVFA 5 yrs, 18%)
Investment
NPV

$ 101,626
$(110,000)
$ (8,374)

B.
Inflation rate
Nominal rate
Income tax rate
Initial investment
Terminal cash flow
Incremental operating cash flow

$
$
$

5%
18.0%
25%
110,000
36,000

Period
Incremental Operating Cash Flows
Inflated
Less taxes

1
$36,000

2
$36,000

3
$36,000

4
$36,000

5
$36,000

$37,800
-$9,450

$39,690
-$9,923

$41,675
-$10,419

$43,758
-$10,940

$45,946
-$11,487

Terminal Cash Flow (inflated)

Income Taxes on Gain
Total Relevant Cash Flow
Calculation of depreciation tax shield
MACRS Rate (5-year)
Depreciation Deduction (nominal)
Tax savings

Present value of annual cash flows

Incremental cash flows
Tax savings from depreciation
Total

28,350

20.00%
22,000 $
$5,500

32.00%
35,200 $
$8,800

28,350
$5,500
33,850

29,768
$8,800
38,568

$
$

Present value
Sum of annual cash flows
Less initial investment
Net present value

$28,686
$
$
$

$
$

29,768

$27,699

$
$

31,256

34,460

19.20%
21,120 $
$5,280

11.52%
12,672 $
$3,168

11.52%
12,672
$3,168

31,256
$5,280
36,536

32,819
$3,168
35,987

34,460
$3,168
37,628

$22,237

$
$

32,819

$18,562

$
$

$16,447

113,631
110,000
3,631

C. When the cash flows are inflated, the discount rate and cash flows are valued consistently
in nominal terms. Therefore incorporating inflation increases the accuracy of the
analysis. Using a nominal discount rate with real cash flows underestimated the cash
flows and understated the net present value.

12-20 Cost Management

D. Inflation rates change over time. Although they have been quite low over a number of
years, if gasoline or labor costs inflate, general inflation will increase. If cash flows from
developing countries are being valued, inflation rates could be quite high and quite
volatile, and become difficult to predict.
E. If managers are using a nominal discount rate and real cash flows, they will consistently
reject projects that could have a positive NPV under the nominal method.
12.30 Quik Computers
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at www.wiley.com/college/eldenburg).
A. The problem does not specify whether the nominal or real method should be used.
Because only a single inflation rate applies to all cash flows, the NPV is identical under
both methods. Below are excerpts from the sample spreadsheet for each method.
Nominal Method:

Chapter 12: Strategic Investment Decisions 12-21

Real method:

B. Any assumptions are uncertain. These include all of the variables in the analysis. They
are all uncertain because they are all affected by changes in the economy, changes in
consumer patterns, and changes in technology, among others.
C. Technology changes could reduce the effectiveness of the diagnostic equipment over
time. If there are rapid and unexpected changes in technology, the equipment could
become obsolete relatively quickly. People will have older computers that need work,
but the service division may not be able to use the equipment on newer machines, and
have to buy new equipment sooner than expected. This would lead to decreases in
revenues prior to purchase of new equipment and increases in costs over time when
newer equipment is purchased.
D. All of the variables in the input section can be varied. Students should use their judgment
to determine the factors that are most likely to change rapidly, and the amounts by which
they will change.
E. The answer will vary depending on the factors and range of values used. The purpose of
this question is to encourage students to learn more about NPV and sensitivity analysis by
exploring how fluctuations in different factors affect NPV results. Students may have
difficulty deciding (1) which factors are likely to have a significant effect, and (2) how

12-22 Cost Management

much to modify each factor in their sensitivity analyses. Students should use reasonable
judgment in making these decisions and explain their reasoning.
F. Student answers to this question will vary. However, here are some examples of pros and
cons.
Pros

The diagnostic system may improve service quality, increasing

customer satisfaction.

It may reduce the amount of time that machines are in the shop.
Cons

Kelly does not know for certain whether the diagnostic machine will
reduce costs as much as anticipated.
The equipment could break down more often than expected.
Employees may need special training and, if employee turnover is
high, this could be a problem.

G. There is no one answer to this part. Sample solutions and a discussion of typical student
responses will be included in assessment guidance on the Instructors web site for the
textbook (available at www.wiley.com/college/eldenburg).
12.31 The Hotshots
A. Following is the time line incorporating the algebraic approach to the solution. Notice
that S is used for salary because the problem gives no information about its value. Nor
does the problem provide information about the tax consequences of buying the house.
Following are two solutions using two different assumptions. The first solution assumes
no tax consequences for the $5 million house. The second solution assumes that the
house could be amortized as a business expense over 4 years (the length of the contract).
Solution #1: Cash Flow Timeline
Investment
Incremental cash flows:
Incremental revenues
Incremental salary
Incremental taxes
Net cash flow

Time 0
$(13,000,000)

Years1-4
$6,000,000
(S)
$(800,000) + 0.20S
$5,200,000 0.80S

(a)
(b)

(a) Incremental revenues = $2 million + $2.5 million + $0.5 million + $1

million = $6 million
(b) Amortization = $2,000,000 per year
Incremental Taxes = ($6,000,000 $2,000,000 S) x 20%
= $(800,000) + 0.20S

Chapter 12: Strategic Investment Decisions 12-23

Solution #2: Cash Flow Timeline
Investment
Incremental cash flows:
Incremental revenues
Incremental salary
Incremental taxes
Net cash flow

Time 0
$(13,000,000)

Years1-4
$6,000,000
(S)
$(550,000) + 0.20S
$5,450,000 0.80S

(a)
(b)

(a) Incremental revenues = $2 million + $2.5 million + $0.5 million + $1

million = $6 million
(b) Amortization = $2,000,000 per year + $5,000,000/4 = $3,250,000
Incremental Taxes = ($6,000,000 $3,250,000 S) x 20%
= $(550,000) + 0.20S
B. The maximum salary is the salary that will bring the NPV to zero. Solve this problem
algebraically by setting NPV equal to zero and solving for S:
Solution #1:
0 = $(13,000,000) +[ (PVFA 4 years, 12%) x ($5,200,000 0.8S)]
0 = $(13,000,000) + [3.037 x ($5,200,000 0.8S)]
$2,792,400 = 2.4296S
S = $1,149,325
Based on these computations, Cliff could afford to pay up to $1,149,325 in salary
annually.
Solution #2:
0 = $(13,000,000) + [(PVFA 4 years, 12%) x ($5,450,000 0.8S)]
0 = $(13,000,000) + [3.037 x ($5,450,000 0.8S)]
$3,551,650 = 2.4296S
S = $1,461,825
Based on these computations, Cliff could afford to pay up to $1,461,825 in salary
annually.
C. Here are factors that could affect Cliffs willingness to sign Bob; students will probably
think of others:

Are there other competing sports in the area that are played at the same time,
for example college team sports?
Does Bob have a dubious reputation that could lead to behavior that would
turn fans against him and the team?
Will other team mates resent having a highly paid team member when their
salaries may not be nearly as high?

12-24 Cost Management

If the team does not have a winning season, even after Bob has been signed,
will attendance fall off?

D. The signing bonus and the cost of housing for Bob would be certain once the contract is
signed. However, there is uncertainty about the incremental revenue cash flows. For
example, Cliff cannot know whether fans will react to Bob in the way these estimates
predict. It is possible that bad publicity could arise about Bobs behavior, which could
change the expected increases in revenues. Fans can be unpredictable, and this could
change the revenues greatly. Bob could become injured, and fan support would decrease.
It is possible that a competing sport will reduce the amount of expected revenues. There
is also uncertainty about the income tax cash flows. Income tax regulations could
change, altering the tax rate or the deductibility of costs.
12.32 Wildcat Welders, Inc.
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at www.wiley.com/college/eldenburg).
A. Below is an excerpt from the sample spreadsheet showing calculations under the nominal
method. The NPV for the project is $8,101,087.

B. Worker safety could easily override a negative NPV value. In addition, sometimes
insurance companies will no longer insure individuals or businesses if they do not
manage their risk of liability claims well. For example, homeowners insurance is
cancelled for people who own certain breeds of dogs that are known to bite people after
the first claim.
C.
1. Students will have a number of different responses to this question. However, their
logic should include the fact that this is replacement of equipment, which tends to be

Chapter 12: Strategic Investment Decisions 12-25

less risky than offering new products or services because the company has experience
with the original equipment.
2. As the risk premium increases, the discount rate also increases. As the discount rate
increases, the NPV values decrease. So an increase in the discount rate decreases the
NPV.
3. Because the new equipment lowers Wildcats risk of future cash outflows from
liability suits, it decreases their risk and therefore the risk premium should be lower.
D.
1. Students will have various responses, but they should consider potential changes in
labor cost that would tend to increase, and insurance, which might tend to decrease if
Wildcats safety record improves.
2. If cash savings increase, NPV should also increase, and vice versa.
3. This can be determined from the spreadsheet by reducing the incremental operating
cash flow in the input box. Through trial and error, it can be determined that NPV is
nearly zero when annual cash flows are $2,553,195.
E. If current inflation is 2% and the inflation in the analysis is 5%, the inflation rate may be
too high if current trends persist. However, when inflation or risk free rates are unusually
low, these rates will be expected to increase over time. The choice, then, is a matter of
judgment. Students will have a variety of answers, but should consider current
information about inflation trends.
12.33 Ford Motor Company
A.
1. Some students will have heard about the Ford Pinto, and others will not. If students
have heard about the Pinto, they most likely have negative impressions of Fords
decisions regarding the Pinto.
2. Students may feel that Ford was callous or even negligent in its actions. These
impressions can prevent students from objectively analyzing information when
responding to the remaining questions.
B. The major conflict of interest in this case involves Fords profitability from sales of the
Pinto versus the interests of individuals and others who were harmed (physically,
emotionally, or financially) from the gasoline tank explosions. The managers had an
ethical dilemma over whether or how much to spend in additional testing, redesign,
and/or recalls of the Pinto. Most people understand that absolute automobile safety is not
achievable; they are not willing to pay beyond some unknown amount of cost for vehicle
safety. Thus, the managers could not perfectly anticipate the level of safety that
customers required or their willingness to pay a higher price. At the same time, however,
the public expected some level of safety assurance from the Pinto. The managers needed

12-26 Cost Management

to weigh the interests of the company and its shareholders against the interests of
consumers, passengers, and others.
Another ethical issue in this case relates to governmental regulators. Regulators were
responsible for setting and monitoring minimum safety standards, but they were also
responsible for ensuring that standards did not become too burdensome for the
automobile companies. In addition, the regulators had an ethical responsibility to treat
automobile companies fairly, such as holding all companies to the same standard. The
regulators faced ethical conflicts among these responsibilities in deciding how to respond
to the Pinto case and also in setting new regulations.
Other automobile manufacturers also faced an ethical dilemma related to this case. When
new federal regulations were established, these companies needed to consider whether
they should evaluate older models for possible redesign or recall. In making their
decisions, these companies were faced with ethical issues similar to those of Ford.
However, their managers were under less public pressure because only the Pinto had been
publicized as having problems. Nevertheless, all of the automobile companies sold cars
with varying degrees of safety problems.
Jury members in the Pinto trials also faced an ethical dilemma. They needed to weigh the
harm done and the reasonableness of consumer expectations against Fords actions,
taking into account governmental regulations.
C. Numerous costs were probably ignored in the cost-benefit analysis. Managers
overlooked the high reputation costs of their behavior. Their loss of reputation hurt not
only sales of the Pinto, but it probably also reduced sales of other Ford products. The
loss of reputation also contributed to increased competition from Japanese auto makers,
who were seen as more concerned about high quality. In addition, Ford incurred high
costs to redesign and recall the Pinto, and it most likely spent considerable sums to
overcome negative publicity.
D. Below are discussions of the pros and cons for the two measures from the perspective of
various stakeholders.
Measure used by Ford: Expected future cost of settling lawsuits filed on behalf of burn
victims.
Pros: This type of measure was traditionally used by companies to evaluate costs; it
was consistent with commonly-used expected future cash flow analysis for business
decisions. In addition, this type of measure had previously been used by regulators.
Thus, Fords managers probably assumed that this was an appropriate measure to use.
Other U.S. automobile companies probably used a similar measure in their own costbenefit analyses.
Cons: As discussed in Part C, this measure did not take into account numerous
opportunity costs. Thus, it was not a very complete measure of expected future cash
flows. Fords shareholders and employees would have preferred a more complete
measure, which might have led Fords managers to different decisions in this case.
The public, which included crash victims as well as potential and existing owners of

Chapter 12: Strategic Investment Decisions 12-27

Ford and other vehicles, were outraged at the idea that lawsuit costs were used by
Ford in a cost-benefit analysis. They believed that this measure demonstrated
callousness and unethical behavior. Fords managers, shareholders, employees, and
others would have preferred a different measure if they could have foreseen this
reaction. Faced with public scrutiny, the regulators decided not to use this measure in
their analysis of the Pinto problem.
Measure used by NHTSA: Societal value of human life.
Pros: This measure allowed consideration not only of immediate economic costs, but
also of indirect costs including lost incomes. Thus, it was a more complete measure
of the cost of Pinto safety problems. This measure was most likely considered
reasonable by the general public, victims, families, current and prospective Pinto
owners, and customers of other Ford brands. These stakeholders would have been
pleased at holding Ford to a greater level of social responsibility, which they probably
wanted extended to other companies and industries. Fords employees also might
have viewed this measure as more appropriate, even though it might have contributed
to declining sales and loss of jobs at Ford. Obviously, the regulators decided to use
this measure in their analysis; they probably believed that it would demonstrate their
concern for the public interest. This measure combined with regulatory changes
might also have improved long-term consumer confidence in U.S. automobiles,
which would have provided long-term benefit to the companies, shareholders,
employees, and U.S. economy. It also led to higher safety standards, reducing future
personal and social losses.
Cons: This measure constituted a major deviation from prior practice and held Ford
to a higher standard than other automobile companies. Fords shareholders and
managers probably believed that the measure held them to an unfair and inappropriate
standard. Adoption of this measure by regulators might have contributed to a decline
in automobile sales at Ford and other U.S. automobile manufacturers. It might also
have contributed to even more litigation against companies throughout the U.S.
economy, leading to higher costs, decreased profits, and loss of jobs.
The preceding discussions did not address the preferences of Japanese automobile
companies. It is not clear whether these companies used cost-benefit analyses similar to
those used by U.S. automobile manufacturers. However, after World War II, Japanese
manufacturers were actively involved in continuous improvement efforts aimed at higher
product quality and by the 1970s had achieved a reputation for high quality. If Japanese
automobile manufacturers definitions of higher quality also included greater vehicle
safety, then they might not have used either of the measures discussed above. Instead,
these manufacturers would have sought ways to eliminate safety problems regardless of
how the cost was measured.
E. Fords managers were probably concerned primarily with meeting government
requirements and maintaining their profit margins. During the late 1970s, manufacturers
were not as concerned about quality or consumer responses to their decisions.
Competition had been limited to a relatively small group of manufacturers, many of
whom held similar values. The managers may have believed that their response was

12-28 Cost Management

appropriate at the time. However, public outcries might have led them to give greater
future consideration to the viewpoints of others.
F. In reaching conclusions about the Pinto, NHTSA staff gave more consideration to the
societal value of human life than to Fords profitability. They might have chosen this
weighting of values because of the public outcry over the Pinto problems. Prior to this
episode, it appears that NHTSA staff had adopted values closer to those described in Part
E for Fords managers. It is possible that this change was appropriate under the
circumstances because it reflected a social shift toward holding companies to a higher
level of responsibility. It is also possible to argue that the shift was implemented
inappropriately in this circumstance because Ford was held to a standard that did not exist
at the time the vehicles were manufactured, and other companies were not held to the
same standard.

Chapter 12: Strategic Investment Decisions 12-29

12.34 Favorite Fish
The spreadsheet template for this problem is available on the Instructors web site for the
textbook (available at www.wiley.com/college/eldenburg). Below is an excerpt of the contents
of the spreadsheet.

A. ($22,900)
B. ($15,288)
C. ($31,323)
D. $5.79
E. $6,701
F. ($22,497)

12-30 Cost Management

G. ($21,596)
H. ($40,288)
I. $6.05
J. $6.16
K. $6.63
L. Current tax rates can be accessed on the Internet (e.g., www.irs.gov). For discount rates,
think about alternative investments for this company at similar levels of risk. For price
information, investigate prices of competitors and examine trade journals. Cost
information may be more difficult to find; one would need to work in the industry to
know the costs.

Chapter 12: Strategic Investment Decisions 12-31

BUILD YOUR PROFESSIONAL COMPETENCIES

12.35 Focus on Professional Competency: Industry/Sector Perspective
A.
1. Managers in relatively stable industries and sectors place greater confidence in future
cash flow estimates. In contrast, managers in less stable industries have less
confidence in their cash flow estimates. For example, cash flows are highly uncertain
in industries that are subject to rapid technological change or fluctuating resource
costs. Even relatively stable industries become less stable with changes in the
regulatory environment or new forms of competition. The certainty of long term
investment decisions depends not only on the individual company, but also on the
industry/sector.
2. Competitive advantages are a companys strengths and opportunities relative to
competitors. Advantages can include greater product quality or closer relationships
with customers, leading to higher revenues, or it can include greater production
efficiency or arrangements with suppliers, leading to lower costs. Advantages can
also include the ability to take advantage of favorable income tax rates. Companies
having competitive advantages also face less risk, leading to a lower required
discount rate for investment projects.
3. The effects of competitive disadvantages are opposite those described in Part A.2 for
competitive advantages. A companys weaknesses relative to competitors can cause it
to lose a greater proportion of revenues due to competition or an economic downturn.
Its costs can also be less stable, leading to a greater likelihood that they exceed
expectations. For example, a weaker company may have unreliable supplier
relationships. NPV is based on expected values. However, competitive
disadvantages can cause results to be less favorable than expected.
4. Managers who propose a project are often biased toward project acceptance, as
discussed through the Motorola Iridium case in Chapter 1. Managers have a tendency
to overestimate a projects advantages and to underestimate its disadvantages. In
addition, competitive disadvantages are sometimes difficult to identify. For example,
managers may be unaware of competing projects that are under development among
competitors.
B. There are many ways to monitor long-term investment projects to address risks over time.
Here are two ideas; students may think of others. One approach is to measure and
compare the project cash flows to expectations and investigate reasons for differences.
Another approach is to periodically re-evaluate the projects strengths and weaknesses,
considering changes in the competitive and economic environment.
C. GlaxoSmithKline and other large pharmaceutical companies are often criticized for
failing to develop drugs needed in underdeveloped countries or to sell drugs in those
countries at low prices. Partnership with an organization such as the World Health
Organization (WHO) is a highly visible way to address this type of criticism. In addition,

12-32 Cost Management

WHO has existing supply chain relationships in underdeveloped countries that would
make it easier for GlaxoSmithKline to distribute drugs in those countries.
12.36 Integrating Across the Curriculum: Finance
A. The calculation of weighted average cost of capital requires three steps. First calculate
the relative proportion of capital from each source:
Proportion
Source of Capital
Market Value
of Capital
Short-term debt
$ 300,000
$300,000/$2,300,000 13.04%
Bonds
900,000
$900,000/$2,300,000 39.13
Leases
200,000
$200,000/$2,300,000
8.70
Common stock
900,000
$900,000/$2,300,000 39.13
Total
$2,300,000
100.00%
Next calculate the after-tax cost for each source of capital. The after-tax cost for debt is
the pretax cost multiplied by one minus the income tax rate:
Pretax
After-Tax
Source of Capital
Cost
Cost
Short-term debt
8%
8%*(1-25%)
6.00%
Bonds
6
6%*(1-25%)
4.50
Leases
7
7%*(1-25%)
5.25
Common stock
10
10.00
Finally, calculate the weighted cost for each source of capital by multiplying its after-tax
cost by its proportion of the total capital. The sum of the weighted cost for all sources of
capital is the weighted average cost of capital:
After-Tax
Weighted
Source of Capital
Cost
Proportion
Cost
Short-term debt
6.00%
13.04%
0.7824%
Bonds
4.50
39.13
1.7609
Leases
5.25
8.70
0.4567
Common stock
10.00
39.13
3.9130
Weighted average cost of capital
6.9130%
B. Because interest paid on various forms of debt is tax-deductible, the actual cost of debt is
the interest cost less the income tax benefit. Thus, the cost of debt must be calculated as
an after-tax cost.
C. Ideally, the discount rate in a capital budgeting problem should be the return on other
investment opportunities of similar risk. However, it is not possible to perfectly identify
the level of risk associated with a project; the project may be more or less risky than
managers expect. It is also not possible to know for certain the rate of return for future
projects having similar levels of risk. In addition, it is more difficult for managers to
identify an appropriate discount rate for projects that are different from the ones with
which they have experience.

Chapter 12: Strategic Investment Decisions 12-33

D. The weighted average cost of capital is useful for projects that are similar in risk to the
average risk of the companys existing projects. It is a measure with which managers are
familiar and understand. In addition, it may appear to be a fair measure across
divisions and projects.
However, the WACC is inappropriate if the risk level of the proposed project is higher or
lower than average, leading to inappropriate rejection or acceptance.
E. Below are alternative ways to estimate the market values for each type of capital.
Short-term debt: Unless interest rates or the companys level of risk have changed
dramatically, the market value of short-term debt is fairly close to its face value.
Bonds: If the bonds are publicly traded, then the market value is readily available. If the
bonds are not publicly traded, then the market value of the bonds could be estimated by
discounting the future principal and interest payments using a discount rate that would be
appropriate, given a current risk premium for the companys level of risk. Alternatively,
the book value could be used to estimate the market value.
Leases: The market value could be estimated by discounting future lease payments using
the interest rate the company would currently incur to purchase a similar asset.
Alternatively, the book value could be used to estimate the market value.
Common stock: If the companys stock is publicly traded, then the market value is
readily available. If the stock is not publicly traded, then the book value of stockholders
equity could be used to estimate the market value. Alternatively, the market value could
be estimated by discounting expected future earnings.
F. Financial statement book values often bear little relation to current market values.
Financial statements do not recognize increases in the value of most assets above cost,
and many intangible assets are not valued at all. Also, the values of liabilities such as
bonds are not adjusted for changes in interest rates or risk. The proportion of capital from
different sources might be significantly distorted by financial statement values, leading to
distortion of the WACC calculation.