To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12 Capital Budgeting Decisions Solutions to Questions 12-1 Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15% rate of return Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle 12-2 The ―time value of money‖ refers to the fact that a dollar received today is more valuable than a dollar received in the future simply because a dollar received today can be invested to yield more than a dollar in the future 12-3 Discounting is the process of computing the present value of a future cash flow Discounting gives recognition to the time value of money and makes it possible to meaningfully add together cash flows that occur at different times 12-4 Accounting net income is based on accruals rather than on cash flows The net present value method focuses on cash flows 12-5 Discounted cash flow methods are superior to other methods of making capital budgeting decisions because they recognize the time value of money and take into account all future cash flows 12-8 No The cost of capital is not simply the interest paid on long-term debt The cost of capital is a weighted average of the individual costs of all sources of financing, both debt and equity 12-9 The cost of capital is a hurdle that must be cleared before an investment project will be accepted In the case of the net present value method, the cost of capital is used as the discount rate If the net present value of the project is positive, then the project is acceptable because its rate of return is greater than the cost of capital 12-10 No As the discount rate increases, the present value of a given future cash flow decreases For example, the present value factor for a discount rate of 12% for cash to be received ten years from now is 0.322, whereas the present value factor for a discount rate of 14% over the same period is 0.270 If the cash to be received in ten years is $10,000, the present value in the first case is $3,220, but only $2,700 in the second case Thus, as the discount rate increases, the present value of a given future cash flow decreases 12-6 Net present value is the present value of cash inflows less the present value of the cash outflows The net present value can be negative if the present value of the outflows is greater than the present value of the inflows 12-11 The internal rate of return is more than 14% since the net present value is positive The internal rate of return would be 14% only if the net present value (evaluated using a 14% discount rate) is zero The internal rate of return would be less than 14% if the net present value (evaluated using a 14% discount rate) is negative 12-7 One simplifying assumption is that all cash flows occur at the end of a period Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate 12-12 The project profitability index is computed by dividing the net present value of the cash flows from an investment project by the investment required The index measures the profit (in terms of net present value) © The McGraw-Hill Companies, Inc., 2010 Solutions Manual, Chapter 12 613 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com provided by each dollar of investment in a project The higher the project profitability index, the more desirable is the investment project 12-13 The payback period is the length of time for an investment to fully recover its initial cost out of the cash receipts that it generates The payback method is used as a screening tool for investment proposals The payback method is useful when a company has cash flow problems The payback method is also used in industries where obsolescence is very rapid 12-14 Neither the payback method nor the simple rate of return method considers the time value of money Under both methods, a dollar received in the future is weighed the same as a dollar received today Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered © The McGraw-Hill Companies, Inc., 2010 614 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12-1 (10 minutes) Item Annual cost savings Initial investment Net present value 1-8 Now Cash Flow 12% Factor $7,000 4.968 $(40,000) 1.000 Cash Flow Years Total Cash Flows Year(s) Present Value of Cash Flows $ 34,776 (40,000) $ (5,224) Item Annual cost savings $7,000 Initial investment $(40,000) Net cash flow $ 56,000 (40,000) $ 16,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 615 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12-2 (10 minutes) The project profitability index for each proposal is: Proposal Number A B C D Net Present Value (a) $36,000 $38,000 $35,000 $40,000 Investment Required (b) $90,000 $100,000 $70,000 $120,000 Project Profitability Index (a)  (b) 0.40 0.38 0.50 0.33 The ranking is: Proposal Project Profitability Number Index C A B D 0.50 0.40 0.38 0.33 Note that proposal D has the highest net present value, but it ranks lowest in terms of the project profitability index © The McGraw-Hill Companies, Inc., 2010 All rights reserved 616 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12-3 (10 minutes) The payback period is determined as follows: Year Investment Cash Inflow 10 $15,000 $8,000 $1,000 $2,000 $2,500 $4,000 $5,000 $6,000 $5,000 $4,000 $3,000 $2,000 Unrecovered Investment $14,000 $20,000 $17,500 $13,500 $8,500 $2,500 $0 $0 $0 $0 The investment in the project is fully recovered in the 7th year To be more exact, the payback period is approximately 6.5 years Because the investment is recovered prior to the last year, the amount of the cash inflow in the last year has no effect on the payback period © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 617 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12-4 (10 minutes) This is a cost reduction project, so the simple rate of return would be computed as follows: Operating cost of old machine Less operating cost of new machine Less annual depreciation on the new machine ($120,000 ÷ 10 years) Annual incremental net operating income $ 30,000 12,000 12,000 $ 6,000 Cost of the new machine Scrap value of old machine Initial investment $120,000 40,000 $ 80,000 Simple rate = Annual incremental net operating income of return Initial investment = $6,000 = 7.5% $80,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 618 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12-5 (15 minutes) The payback period is: Payback period = Investment required Annual net cash inflow = ¥432,000 = 4.8 years ¥90,000 No, the equipment would not be purchased because the payback period (4.8 years) exceeds the company’s maximum payback time (4.0 years) The simple rate of return would be computed as follows: Annual cost savings Less annual depreciation (Ơ432,000 ữ 12 years) Annual incremental net operating income Simple rate of return = = ¥90,000 36,000 ¥54,000 Annual incremental net operating income Initial investment ¥54,000 = 12.5% ¥432,000 No, the equipment would not be purchased because its 12.5% rate of return is less than the company’s 14% required rate of return © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 619 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12-6 (10 minutes) Item Project X: Initial investment Annual cash inflow Net present value Project Y: Initial investment Single cash inflow Net present value Amount of Year(s) Cash Flows 18% Factor Present Value of Cash Flows Now 1-10 $(35,000) $9,000 1.000 4.494 $(35,000) 40,446 $ 5,446 Now 10 $(35,000) $150,000 1.000 0.191 $(35,000) 28,650 $( 6,350) Project X should be selected Project Y does not provide the required 18% return, as shown by its negative net present value © The McGraw-Hill Companies, Inc., 2010 All rights reserved 620 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12-7 (10 minutes) Purchase of the stock Annual cash dividends Sale of the stock Net present value Present Amount of 14% Value of Year(s) Cash Flows Factor Cash Flows Now 1-3 $(13,000) $420 $16,000 1.000 2.322 0.675 $(13,000) 975 10,800 $ (1,225) No, Kathy did not earn a 14% return on the Malti Company stock The negative net present value indicates that the rate of return on the investment is less than the minimum required rate of return of 14% © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 621 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12-8 (15 minutes) Item Project A: Cost of equipment Annual cash inflows Salvage value of the equipment Net present value Project B: Working capital investment Annual cash inflows Working capital released Net present value Year(s) Amount of Cash Inflows 14% Factor Present Value of Cash Flows Now 1-6 $(100,000) $21,000 1.000 3.889 $(100,000) 81,669 0.456 3,648 $ (14,683) $8,000 Now 1-6 $(100,000) $16,000 1.000 3.889 $(100,000) 62,224 $100,000 0.456 45,600 $ 7,824 The $100,000 should be invested in Project B rather than in Project A Project B has a positive net present value whereas Project A has a negative net present value © The McGraw-Hill Companies, Inc., 2010 All rights reserved 622 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 12-22A (60 minutes) The net cash inflow from sales of the device for each year would be: Year 4-12 Sales in units 6,000 12,000 15,000 18,000 Sales in dollars (@ $35 each) $ 210,000 $420,000 $525,000 $630,000 Variable expenses (@ $15 each) 90,000 180,000 225,000 270,000 Contribution margin 120,000 240,000 300,000 360,000 Fixed expenses: Salaries and other* 110,000 110,000 110,000 110,000 Advertising 180,000 180,000 150,000 120,000 Total fixed expenses 290,000 290,000 260,000 230,000 Net cash inflow (outflow) $(170,000) $(50,000) $ 40,000 $130,000 * Depreciation is not a cash expense and therefore must be eliminated from this computation The analysis is: ($315,000 – $15,000 = $300,000) ÷ 12 years = $25,000 depreciation; $135,000 total expense – $25,000 depreciation = $110,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 642 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 12-22A (continued) The net present value of the proposed investment would be: Item Investment in equipment Working capital needed Yearly cash flows (see above) Yearly cash flows (see above) Yearly cash flows (see above) Yearly cash flows (see above) Salvage value of equipment Release of working capital Net present value Amount of 14% Year(s) Cash Flows Factor Now Now 4-12 12 12 $(315,000) $(60,000) $(170,000) $(50,000) $40,000 $130,000 $15,000 $60,000 Present Value of Cash Flows 1.000 $(315,000) 1.000 (60,000) 0.877 (149,090) 0.769 (38,450) 0.675 27,000 3.338 * 433,940 0.208 3,120 0.208 12,480 $ (86,000) * Present value factor for 12 periods 5.660 Present value factor for periods 2.322 Present value factor for periods, starting periods in the future 3.338 Since the net present value is negative, the company should not accept the device as a new product © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 643 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Ethics Challenge (60 minutes) Rachel Arnett’s revision of her first proposal can be considered a violation of the IMA’s Statement of Ethical Professional Practice She discarded her reasonable projections and estimates after she was questioned by William Earle She used figures that had a remote chance of occurring By doing this, she violated the requirements to ―Communicate information fairly and objectively‖ and ―disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.‖ By altering her analysis, she also violated the Integrity standard She engaged in an activity that would prejudice her ability to carry out her duties ethically In addition, she violated the Competence standard—―Provide decision support information and recommendations that are accurate, clear, concise, and timely.‖ Earle was clearly in violation of the Standards of Ethical Conduct for Management Accountants because he tried to persuade a subordinate to prepare a proposal with data that was false and misleading Earle has violated the standards of Competence (Provide decision support information and recommendations that are accurate, clear, concise, and timely.), Integrity (Mitigate actual conflicts of interest Regularly communicate with business associates to avoid apparent conflicts of interest.), and Credibility (Communicate information fairly and objectively Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.) © The McGraw-Hill Companies, Inc., 2010 All rights reserved 644 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Ethics Challenge (continued) The internal controls Fore Corporation could implement to prevent unethical behavior include:  approval of all formal capital expenditure proposals by the Controller and/or the Board of Directors  designating a non-accounting/finance manager to coordinate capital expenditure requests and/or segregating duties during the preparation and approval of capital expenditure requests  requiring that all capital expenditure proposals be reviewed by senior operating management, which includes the Controller, before the proposals are submitted for approval  requiring the internal audit staff to review all capital expenditure proposals or contracting external auditors to review the proposal if the corporation lacks manpower (Unofficial CMA Solution, adapted) © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 645 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Analytical Thinking (60 minutes) Perhaps the clearest approach to a solution is as follows: Item Purchase of facilities: Initial payment—property Annual payments—property Annual cash operating costs Resale value of the property Net present value Lease of facilities: Initial deposit First lease payment Remaining lease payments Annual cost of repairs, etc Return of deposit Net present value Amount of 16% Year(s) Cash Flows Factor Present Value of Cash Flows Now 1-4 1-18 18 $(350,000) $(175,000) $(20,000) $500,000 1.000 2.798 5.818 0.069 $(350,000) (489,650) (116,360) 34,500 $(921,510) Now Now 1-17 1-18 18 $(8,000) $(120,000) $(120,000) $(4,500) $8,000 1.000 1.000 5.749 5.818 0.069 $ (8,000) (120,000) (689,880) (26,181) 552 $(843,509) Net present value in favor of leasing the facilities $ 78,001 This is a least-cost decision, and, as shown above, the total-cost approach is the simplest way to handle the data The problem with Sam Watkin’s approach, in which he simply added up the payments, is that it ignores the time value of money The purchase option ties up large amounts of funds that could be earning a return elsewhere © The McGraw-Hill Companies, Inc., 2010 All rights reserved 646 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Analytical Thinking (continued) The incremental-cost-approach can also be used, although this approach is harder to follow and would not be as clear in a presentation to the executive committee The data could be arranged as follows: Buy rather than lease: Item Incremental initial payment ($350,000 – $120,000 = $230,000) Deposit avoided by purchasing Annual payments— property Lease payments avoided Additional cash operating costs ($20,000 – $4,500 = $15,500) Difference between resale value and deposit at end ($500,000 – $8,000 = $492,000) Net present value Amount of 16% Year(s) Cash Flows Factor Now Now $(230,000) $8,000 1.000 1.000 Present Value of Cash Flows $(230,000) 8,000 1-4 1-17 $(175,000) $120,000 2.798 5.749 (489,650) 689,880 1-18 $(15,500) 5.818 (90,179) 18 $492,000 0.069 33,948 $ (78,001) If Sam Watkins brings up the issue of the building’s future sales value, it should be pointed out that a property that can be sold for $500,000 in 18 years has a present value of only $34,500 if a company can invest money at 16% In other words, a high future sales value is often worth very little in terms of present value when money can be invested at a high rate of return, such as in the case of Top-Quality Stores Note that the building’s sale value could be three times as high in 18 years (i.e., $1,500,000) and the lease alternative would still be better than the purchase alternative © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 647 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Case (90 minutes) This least-cost problem can be worked either using the total-cost or the incremental-cost approach Both solutions are given below Regardless of which approach is used, we must first compute the annual production costs that would result from each of the machines The computations are: Units produced Model 400: Total cost at $0.80 per unit Model 800: Total cost at $0.60 per unit 40,000 $32,000 $24,000 Year 60,000 $48,000 $36,000 80,000 $64,000 $48,000 4-10 90,000 $72,000 $54,000 Using these data, the solution by the total-cost approach would be: Item Alternative 1: Purchase the Model 400 machine: Cost of a new machine Cost of a new machine Market value of the replacement machine Production costs (above) Production costs (above) Production costs (above) Production costs (above) Repairs and maintenance (maintenance for two Model 400 machines @ $2,500 per year) Present value of cash flows Year(s) Amount of Cash Flows Now 10 4-10 $(170,000) $(200,000) $140,000 $(32,000) $(48,000) $(64,000) $(72,000) 1-10 $(5,000) 20% Factor Present Value of Cash Flows 1.000 $(170,000) 0.279 (55,800) 0.162 22,680 0.833 (26,656) 0.694 (33,312) 0.579 (37,056) 2.086 * (150,192) 4.192 (20,960) $(471,296) *See the note on the next page © The McGraw-Hill Companies, Inc., 2010 All rights reserved 648 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Case (continued) Item Alternative 2: Purchase the Model 800 machine: Cost of a new machine Production costs (above) Production costs (above) Production costs (above) Production costs (above) Repairs and maintenance Present value of cash flows Year(s) Amount of Cash Flows 20% Factor Now 4-10 1-10 $(300,000) $(24,000) $(36,000) $(48,000) $(54,000) $(3,800) 1.000 0.833 0.694 0.579 2.086 * 4.192 Net present value in favor of purchasing the model 400 machine Present Value of Cash Flows $(300,000) (19,992) (24,984) (27,792) (112,644) (15,930) $(501,342) $ 30,046 * Present value factor for 10 periods Present value factor for periods Present value factor for periods starting periods in the future 4.192 2.106 2.086 When doing an analysis by the incremental-cost approach, it is necessary to proceed from a perspective of one of the two alternatives Since the Model 800 is the more costly of the two, we will proceed from the perspective of this alternative The computations are provided on the following page © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 12 649 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Case (continued) The solution from an incremental-cost approach would be: Item Incremental cost of the Model 800 machine: Cost avoided on a replacement Model 400 machine Market value forgone on the replacement Savings in production costs Savings in production costs Savings in production costs Savings in production costs Savings on repairs and maintenance costs Net present value of purchasing a Model 800 machine rather than a second Model 400 machine Year(s) Now 10 4-10 1-10 Amount of Cash Flows $(130,000) $200,000 $(140,000) $8,000 $12,000 $16,000 $18,000 $1,200 20% Factor 1.000 0.279 0.162 0.833 0.694 0.579 2.086 4.192 Present Value of Cash Flows $(130,000) 55,800 (22,680) 6,664 8,328 9,264 37,548 5,030 $(30,046) Therefore, the company should purchase a second Model 400 machine rather than purchase the Model 800 machine An increase in labor costs would make the Model 800 machine more desirable because the labor cost per unit of product is only $0.16 on the Model 800 machine, as compared to $0.49 per unit on the Model 400 machine An increase in materials cost would make the Model 800 machine less desirable because the materials cost per unit of product is $0.40 on the Model 800 machine, as compared to only $0.25 per unit on the Model 400 machine © The McGraw-Hill Companies, Inc., 2010 All rights reserved 650 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Appendix 12A The Concept of Present Value Exercise 12A-1 (10 minutes) From Exhibit 12B-1, the factor for 10% for periods is 0.751 Therefore, the present value of the required investment is: $8,000 × 0.751 = $6,008 From Exhibit 12B-1, the factor for 14% for periods is 0.675 Therefore, the present value of the required investment is: $8,000 ì 0.675 = $5,400 â The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 12A 651 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12A-2 (10 minutes) Amount of Cash Flows Investment Investment Year A B $3,000 $6,000 $9,000 $12,000 $12,000 $9,000 $6,000 $3,000 18% Factor 0.847 0.718 0.609 0.516 Present Value of Cash Flows Investment Investment A B $ 2,541 4,308 5,481 6,192 $18,522 $10,164 6,462 3,654 1,548 $21,828 Investment project B is best © The McGraw-Hill Companies, Inc., 2010 652 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12A-3 (10 minutes) The present value of the first option is $150,000, since the entire amount would be received immediately The present value of the second option is: Annual annuity: $14,000 × 7.469 (Exhibit 12B-2) Lump-sum payment: $60,000 × 0.104 (Exhibit 12B-1) Total present value $104,566 6,240 $110,806 Thus, Julie should accept the first option, which has a much higher present value On the surface, the second option appears to be a better choice because it promises a total cash inflow of $340,000 over the 20-year period ($14,000 × 20 = $280,000; $280,000 + $60,000 = $340,000), whereas the first option promises a cash inflow of only $150,000 However, the cash inflows under the second option are spread out over 20 years, causing the present value to be far less © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 12A 653 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12A-4 (10 minutes) From Exhibit 12B-2, the factor for 16% for periods is 4.344 The computer system should be purchased only if its net present value is positive This will occur only if the purchase price is less: $7,000 × 4.344 = $30,408 From Exhibit 12B-2, the factor for 20% for periods is 3.837 Therefore, the maximum purchase price would be: $7,000 ì 3.837 = $26,859 â The McGraw-Hill Companies, Inc., 2010 654 Introduction to Managerial Accounting, 5th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12A-5 (10 minutes) From Exhibit 12B-2, the factor for 12% for 20 periods is 7.469 Thus, the present value of Mr Ormsby’s winnings is: $80,000 × 7.469 = $597,520 Whether or not it is correct to say that Mr Ormsby is the state’s newest millionaire depends on your point of view He will receive more than a million dollars over the next 20 years; however, he is not a millionaire as shown by the present value computation above, nor will he ever be a millionaire if he spends his winnings rather than investing them © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 12A 655 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12A-6 (10 minutes) From Exhibit 12B-1, the factor for 10% for periods is 0.621 Therefore, the company must invest: $500,000 × 0.621 = $310,500 From Exhibit 12B-1, the factor for 14% for periods is 0.519 Therefore, the company must invest: $500,000 × 0.519 = $259,500 © The McGraw-Hill Companies, Inc., 2010 656 Introduction to Managerial Accounting, 5th Edition ... 2010 All rights reserved Solutions Manual, Chapter 12 615 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12- 2 (10 minutes) The project... 2010 All rights reserved Solutions Manual, Chapter 12 617 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Brief Exercise 12- 4 (10 minutes) This... Inc., 2010 All rights reserved Solutions Manual, Chapter 12 621 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 12- 8 (15 minutes) Item Project