To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 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 skills (Identifying)  Step skills (Exploring)  Step skills (Prioritizing)  Step skills (Envisioning) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 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 today’s 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 rate—a more realistic assumption If the discount rate is set equal to the organization’s 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 today’s 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 firm’s 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 12.14 Overnight Laundry Cash Flow Timeline: Investment Incremental cash flows: Annual Savings Taxes Net cash flow Terminal value Time $(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) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 Excel’s 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 = 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 Instructor’s 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 $(100,000) Years1-5 Year 10 $20,000 (0) (b) $20,000 (a) $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%, 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: Investment Incremental cash flows: Annual contribution margin Incremental fixed costs Incremental taxes Net cash flow Terminal value Time $(100,000) 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-8 Cost Management Next, set the NPV equal to zero and solve for Q: = $(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: Risk-adjusted rate Inflation rate Income tax rate Initial investment MACRS depreciation life Incremental operating cash flow: Cases of water Selling price per case Variable cost per case Incremental fixed costs per year 12% 4% 25% $100,000 Nominal discount rate = 16.48% 20,000 $9 $7 $20,000 Period Incremental Operating Cash Flows: Incremental revenues Incremental variable costs Incremental fixed costs Net Less Income Taxes Net incremental operating cash flows $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 Nominal incremental operating cash flows $15,600 $16,224 $16,873 $17,548 $18,250 Calculation of depreciation tax shield MACRS Rate (Exhibit 12A.5) Depreciation Deduction (nominal) Nominal tax savings 33.33% $33,330 $8,333 44.45% $44,450 $11,113 14.81% $14,810 $3,703 Present value of annual cash flows Incremental cash flows Tax savings from depreciation Total incremental cash flows $15,600 8,333 $23,933 $16,224 11,113 $27,337 $16,873 3,703 $20,575 $17,548 1,853 $19,400 $18,250 $18,250 Present value $20,546 $20,148 $13,020 $10,539 $8,511 Sum of PV of annual cash flows Less initial investment Net present value $72,765 ($100,000) ($27,235) 7.41% $7,410 $1,853 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-9 Below is an excerpt from the sample spreadsheet showing calculations using the real method: Risk-adjusted rate Inflation rate Income tax rate Initial investment MACRS depreciation life Incremental operating cash flow: Cases of water Selling price per case Variable cost per case Incremental fixed costs per year 12% 4% 25% $100,000 20,000 $9 $7 $20,000 Period Incremental Operating Cash Flows: Incremental revenues Incremental variable costs Incremental fixed costs Net Less Income Taxes Net incremental operating cash flows $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 Calculation of depreciation tax shield MACRS Rate (Exhibit 12A.5) Depreciation Deduction (nominal) Depreciation deduction (real) Real tax savings 33.33% $33,330 $32,048 $8,012 44.45% $44,450 $41,097 $10,274 14.81% $14,810 $13,166 $3,292 7.41% $7,410 $6,334 $1,584 Present value of annual cash flows Incremental cash flows Tax savings from depreciation Total incremental cash flows $15,000 8,012 $23,012 $15,000 10,274 $25,274 $15,000 3,292 $18,292 $15,000 1,584 $16,584 $15,000 $15,000 Present value $20,546 $20,148 $13,020 $10,539 $8,511 Sum of PV of annual cash flows Less initial investment Net present value $180,000 (140,000) (20,000) 20,000 (5,000) $15,000 $72,765 ($100,000) ($27,235) 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%, 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 years Savings x (PVFA, 10%, 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 investment = -$60,000 Years 1-6: Annual saving Depreciation Total annual after-tax flows $18,000 $18,000 4,000 4,000 $22,000 $22,000 Year $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% 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 Cumulative Cash Inflows 22,000 44,000 66,000 The original investment is $60,000, which is expected to be paid back between and 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-18 Cost Management 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 $(20,000) Years1-5 $6,000 (500) (b) $5,500 Year (a) $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%, 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 years, Irrigation Supply will have lost $1,993 in today’s dollars This means that the investment will not have paid for itself in years Results from the payback method indicate that the investment will be recovered in 3.33 years The payback period is shorter than 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 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 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 $36,000 $36,000 $36,000 $36,000 $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 19.20% 21,120 $ $5,280 11.52% 12,672 $ $3,168 11.52% 12,672 $3,168 28,350 $5,500 33,850 29,768 $8,800 38,568 31,256 $5,280 36,536 32,819 $3,168 35,987 34,460 $3,168 37,628 $ $ Present value Sum of annual cash flows Less initial investment Net present value $ $28,686 $ $ $ $ $ $ 29,768 $27,699 $ $ $ 31,256 $22,237 $ $ $ 32,819 $18,562 $ $ $ 34,460 $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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 Instructor’s 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: Real rate of return Inflation rate Income tax rate Initial investment Straight-line depreciation life Incremental operating cash flow 10% 5% 30% $10,000 $3,000 Nominal discount rate = 15.50% Period Incremental Operating Cash Flows: Incremental Operating Cash Flows: Less Income Taxes Net incremental operating cash flows 3,000 (900) $2,100 3,000 (900) $2,100 3,000 (900) $2,100 3,000 (900) $2,100 3,000 (900) $2,100 Nominal incremental operating cash flows $2,205 $2,315 $2,431 $2,553 $2,680 Calculation of depreciation tax shield Depreciation Deduction (nominal) Nominal tax savings $2,000 $600 $2,000 $600 $2,000 $600 $2,000 $600 $2,000 $600 Present value of annual cash flows Incremental cash flows Tax savings from depreciation Total incremental cash flows $2,205 600 $2,805 $2,315 600 $2,915 $2,431 600 $3,031 $2,553 600 $3,153 $2,680 600 $3,280 Present value $2,429 $2,185 $1,967 $1,771 $1,596 Sum of PV of annual cash flows Less initial investment Net present value $9,948 ($10,000) ($52) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-21 Real method: Real rate of return Inflation rate Income tax rate Initial investment Straight-line depreciation life Incremental operating cash flow 10% 5% 30% $10,000 $3,000 Period Incremental Operating Cash Flows: Incremental Operating Cash Flows: Less Income Taxes Net incremental operating cash flows $3,000 (900) $2,100 $3,000 (900) $2,100 $3,000 (900) $2,100 $3,000 (900) $2,100 $3,000 (900) $2,100 Calculation of depreciation tax shield Depreciation Deduction (nominal) Depreciation deduction (real) Real tax savings $2,000 $1,905 $571 $2,000 $1,814 $544 $2,000 $1,728 $518 $2,000 $1,645 $494 $2,000 $1,567 $470 Present value of annual cash flows Incremental cash flows Tax savings from depreciation Total incremental cash flows $2,100 571 $2,671 $2,100 544 $2,644 $2,100 518 $2,618 $2,100 494 $2,594 $2,100 470 $2,570 Present value $2,429 $2,185 $1,967 $1,771 $1,596 Sum of PV of annual cash flows Less initial investment Net present value $9,948 ($10,000) ($52) 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 Instructor’s 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 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 $(13,000,000) Years1-4 $6,000,000 (a) (S) $(800,000) + 0.20S (b) $5,200,000 – 0.80S (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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 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 $(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: = $(13,000,000) +[ (PVFA years, 12%) x ($5,200,000 – 0.8S)] = $(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: = $(13,000,000) + [(PVFA years, 12%) x ($5,450,000 – 0.8S)] = $(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 Cliff’s 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? If the team does not have a winning season, even after Bob has been signed, will attendance fall off? To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-24 Cost Management 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 Bob’s 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 Instructor’s 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 Real interest rate Inflation rate Income tax rate Initial investment Terminal cash flow Incremental operating cash flow $ $ $ 10% 5% 25% 10,000,000 1,000,000 5,000,000 Nominal interest rate = 15.50% Period Incremental Operating Cash Flows Less Income Taxes Total Relevant Cash Flow $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 (1,250,000) (1,250,000) (1,250,000) (1,250,000) (1,250,000) $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $5,000,000 (1,250,000) $3,750,000 $5,000,000 (1,250,000) $3,750,000 Calculation of depreciation tax shield MACRS Rate (7-year) Depreciation Deduction (nominal) Tax savings 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% $ 1,429,000 $ 2,449,000 $ 1,749,000 $ 1,249,000 $ 893,000 $ 892,000 $ 893,000 $357,250 $612,250 $437,250 $312,250 $223,250 $223,000 $223,250 4.46% 446,000.00 $111,500 Present value of annual cash flows Incremental cash flows Tax savings from depreciation Total $ 3,750,000 357,250 $ 4,107,250 $ 3,750,000 612,250 $ 4,362,250 $ 3,750,000 437,250 $ 4,187,250 $ 3,750,000 312,250 $ 4,062,250 $ 3,750,000 223,250 $ 3,973,250 $ 3,750,000 223,000 $ 3,973,000 $ 3,750,000 223,250 $ 3,973,250 $ 3,750,000 111,500 $ 3,861,500 $3,556,061 $3,269,991 $2,717,584 $2,282,647 $1,933,018 $1,673,504 $1,449,012 $1,219,271 Present value Sum of annual cash flows Less initial investment Net present value $ $ $ $5,000,000 (1,250,000) $3,750,000 18,101,087 10,000,000 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 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 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 less risky than offering new products or services because the company has experience with the original equipment To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-25 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 Because the new equipment lowers Wildcat’s risk of future cash outflows from liability suits, it decreases their risk and therefore the risk premium should be lower D 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 Wildcat’s safety record improves If cash savings increase, NPV should also increase, and vice versa 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 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 Ford’s decisions regarding the Pinto 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 Ford’s 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 to weigh the interests of the company and its shareholders against the interests of consumers, passengers, and others To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-26 Cost Management 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 Ford’s 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, Ford’s 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 Ford’s shareholders and employees would have preferred a more complete measure, which might have led Ford’s managers to different decisions in this case The public, which included crash victims as well as potential and existing owners of 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-27 callousness and unethical behavior Ford’s 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 Ford’s 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 Ford’s 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 Ford’s 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 appropriate at the time However, public outcries might have led them to give greater future consideration to the viewpoints of others To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-28 Cost Management F In reaching conclusions about the Pinto, NHTSA staff gave more consideration to the societal value of human life than to Ford’s 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 Ford’s 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 12.34 Favorite Fish The spreadsheet template for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg) Below is an excerpt of the contents of the spreadsheet INPUT AREA Cost of Equipment Tax depreciable Life Life of project Volume: Cases of sardines Price per case Variable cost per case Year Incremental Income $25,000 25,000 25,000 25,000 25,000 $100,000 5 10,000 $5.00 $2.50 Less Deprn $20,000 20,000 20,000 20,000 20,000 Minimum Price Requirement Cost of Investment Required Annual Cash Flow Year Required After-Tax Cash Flow $27,741 27,741 27,741 27,741 27,741 Taxable Income $5,000 5,000 5,000 5,000 5,000 Allocated Fixed Cost Tax Rate Discount Rate Less Income Taxes @ 40% $2,000 2,000 2,000 2,000 2,000 $20,000 40% 12% After-Tax Add After-Tax Income Deprn Cash Flow $3,000 $20,000 $23,000 3,000 20,000 23,000 3,000 20,000 23,000 3,000 20,000 23,000 3,000 20,000 23,000 PV of Cash Flows Less: Cost of Investment Net Present Value Present Value @ 12% $20,536 18,335 16,371 14,617 13,051 82,910 (100,000) ($17,090) $100,000 $27,741 Less After Tax Deprn Income $20,000 $7,741 20,000 7,741 20,000 7,741 20,000 7,741 20,000 7,741 Pretax Income $12,902 12,902 12,902 12,902 12,902 Plus Deprn $20,000 20,000 20,000 20,000 20,000 Required Incremental Income $32,902 32,902 32,902 32,902 32,902 Required Contrib Margin per Unit $3.29 3.29 3.29 3.29 3.29 Required Price per Unit $5.79 5.79 5.79 5.79 5.79 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-29 A ($22,900) B ($15,288) C ($31,323) D $5.79 E $6,701 F ($22,497) 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-30 Cost Management BUILD YOUR PROFESSIONAL COMPETENCIES 12.35 Focus on Professional Competency: Industry/Sector Perspective A 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 Competitive advantages are a company’s 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 The effects of competitive disadvantages are opposite those described in Part A.2 for competitive advantages A company’s 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 Managers who propose a project are often biased toward project acceptance, as discussed through the Motorola Iridium case in Chapter Managers have a tendency to overestimate a project’s 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 project’s 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, To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12: Strategic Investment Decisions 12-31 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%*(1-25%) 4.50 Leases 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 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-32 Cost Management D The weighted average cost of capital is useful for projects that are similar in risk to the average risk of the company’s 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 company’s 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 company’s 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 company’s 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 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 ... fall off? To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-24 Cost Management D The signing bonus and the cost of housing for Bob would be certain... company and its shareholders against the interests of consumers, passengers, and others To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-26 Cost Management. .. slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-16 Cost Management 12.26 Real Interest Rates A The real rate includes both a risk free rate and a risk premium