To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 14 Capital Budgeting Decisions Solutions to Questions 14-1 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 14-2 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 14-3 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 14-4 Accounting net income is based on accruals rather than on cash flows Both the net present value and internal rate of return methods focus on cash flows 14-5 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 14-6 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 14-7 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 14-8 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 14-9 The internal rate of return is the rate of return on an investment project over its life It is computed by finding the discount rate that results in a zero net present value for the project 14-10 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 In the case of the internal rate of return method, the cost of capital is compared to a project’s internal rate of return If the project’s internal rate of return is greater than the cost of capital, then the project is acceptable 14-11 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 © The McGraw-Hill Companies, Inc., 2010 788 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 14-12 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 14-14 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 14-13 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) provided by each dollar of investment in a project The higher the project profitability index, the more desirable is the investment project 14-15 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 Solutions Manual, Chapter 14 789 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-1 (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 790 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-2 (30 minutes) Annual savings in part-time help Added contribution margin from expanded sales (1,000 dozen × $1.20 per dozen) Annual cash inflows $3,800 1,200 $5,000 Factor of the internal Investment required = rate of return Annual cash inflow = $18,600 = 3.720 $5,000 Looking in Exhibit 14B-2, and scanning along the six-period line, we can see that a factor of 3.720 falls closest to the 16% rate of return The cash flows will not be even over the six-year life of the machine because of the extra $9,125 inflow in the sixth year Therefore, the above approach cannot be used to compute the internal rate of return in this situation Using trial-and-error or some other method, the internal rate of is 22%: Item Initial investment Annual cash inflows Salvage value Net present value Present Amount of 22% Value of Year(s) Cash Flows Factor Cash Flows Now 1-6 $(18,600) $5,000 $9,125 1.000 3.167 0.303 $(18,600) 15,835 2,765 $ © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 14 791 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-3 (15 minutes) The equipment’s net present value without considering the intangible benefits would be: Item Cost of the equipment Annual cost savings Net present value Year(s) Now 1-15 Amount of Cash Flows 20% Present Value Factor of Cash Flows $(2,500,000) 1.000 $400,000 4.675 $(2,500,000) 1,870,000 $ (630,000) The annual value of the intangible benefits would have to be great enough to offset a $630,000 negative present value for the equipment This annual value can be computed as follows: Required increase in present value $630,000 = = $134,759 Factor for 15 years 4.675 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 792 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-4 (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 Solutions Manual, Chapter 14 793 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-5 (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 794 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-6 (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 Solutions Manual, Chapter 14 795 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-7 (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 796 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14-8 (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 Solutions Manual, Chapter 14 797 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Appendix 14A The Concept of Present Value Exercise 14A-1 (10 minutes) From Exhibit 14B-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 14B-1, the factor for 14% for periods is 0.675 Therefore, the present value of the required investment is: $8,000 × 0.675 = $5,400 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 842 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14A-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 All rights reserved Solutions Manual, Appendix 14A 843 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14A-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 14B-2) Lump-sum payment: $60,000 × 0.104 (Exhibit 14B-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 844 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14A-4 (10 minutes) From Exhibit 14B-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 14B-2, the factor for 20% for periods is 3.837 Therefore, the maximum purchase price would be: $7,000 × 3.837 = $26,859 © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14A 845 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14A-5 (10 minutes) From Exhibit 14B-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 846 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14A-6 (10 minutes) From Exhibit 14B-1, the factor for 10% for periods is 0.621 Therefore, the company must invest: $500,000 × 0.621 = $310,500 From Exhibit 14B-1, the factor for 14% for periods is 0.519 Therefore, the company must invest: $500,000 ì 0.519 = $259,500 â The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14A 847 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Appendix 14C Income Taxes in Capital Budgeting Decisions Exercise 14C-1 (10 minutes) Management development program cost Multiply by – 0.30 After-tax cost $100,000 × 70% $ 70,000 Increased contribution margin Multiply by – 0.30 After-tax cash flow (benefit) $40,000 × 70% $28,000 The depreciation deduction is $210,000 ÷ years = $30,000 per year, which has the effect of reducing taxes by 30% of that amount, or $9,000 per year © The McGraw-Hill Companies, Inc., 2010 All rights reserved 848 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14C-2 (20 minutes) Annual cost of operating the present equipment Annual cost of the new dishwashing machine: Cost for wages of operators Cost for maintenance Annual net cost savings (cash inflow) $85,000 $48,000 2,000 50,000 $35,000 The net present value analysis would be as follows: Items and Computations Year(s) Cost of the new dishwashing machine Now Annual net cost savings (above) 1-12 Depreciation deductions* 1-7 Cost of the new water jets Salvage value of the new machine 12 Net present value (1) Amount (2) Tax Effect $(140,000) — $35,000 – 0.30 $20,000 0.30 $(15,000) – 0.30 $9,000 – 0.30 (1)×(2) After-Tax Cash Flows $(140,000) $24,500 $6,000 $(10,500) $6,300 14% Factor Present Value of Cash Flows 1.000 $(140,000) 5.660 138,670 4.288 25,728 0.456 (4,788) 0.208 1,310 $ 20,920 *$140,000 ÷ years = $20,000 per year Yes, the new dishwashing machine should be purchased © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14C 849 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 14C-3 (20 minutes) Items and Computations Project A: Investment in heavy trucks Annual net cash inflows Depreciation deductions* Salvage value of the trucks Net present value Project B: Investment in working capital Annual net cash inflows Release of working capital Net present value (1) Amount Year(s) (1)×(2) Present (2) After-Tax 12% Value of Tax Effect Cash Flows Factor Cash Flows Now 1-9 1-5 $(130,000) — $25,000 – 0.30 $26,000 0.30 $15,000 – 0.30 $(130,000) $17,500 $7,800 $10,500 1.000 5.328 3.605 0.361 $(130,000) 93,240 28,119 3,791 $ (4,850) Now 1-9 $(130,000) — $25,000 – 0.30 $130,000 — $(130,000) $17,500 $130,000 1.000 5.328 0.361 $(130,000) 93,240 46,930 $ 10,170 *$130,000 ÷ years = $26,000 per year © The McGraw-Hill Companies, Inc., 2010 All rights reserved 850 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-4 (20 minutes) Items and Computations Investment in the new trucks Salvage from sale of the old trucks Annual net cash receipts Depreciation deductions* Replacement of motors Salvage from the new trucks Net present value Year(s) Now Now 1-7 1-5 (1) Amount $(350,000) $16,000 $105,000 $70,000 $(45,000) $18,000 (2) Tax Effect 1 1 — – 0.30 – 0.30 0.30 – 0.30 – 0.30 (1)×(2) After-Tax Cash Flows $(350,000) $11,200 $73,500 $21,000 $(31,500) $12,600 16% Factor Present Value of Cash Flows 1.000 $(350,000) 1.000 11,200 4.039 296,867 3.274 68,754 0.552 (17,388) 0.354 4,460 $ 13,893 *$350,000 ÷ years = $70,000 per year Because the project has a positive net present value, the contract should be accepted © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14C 851 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-5 (60 minutes) Items Buy the new trucks: Investment in the trucks Cash from the sale of the old trucks: Sale price received Tax savings from loss on sale* Annual cash operating costs Depreciation deductions ($650,000 ÷ years = $130,000 per year) Salvage value of the new trucks Net present value Year(s) (1) Amount (2) Tax Effect Now $(650,000) — Now 1-7 $85,000 — $35,000 0.30 $(110,000) – 0.30 1-5 $130,000 0.30 $60,000 – 0.30 (1)×(2) After-Tax Cash 12% Flows Factor Present Value of Cash Flows $(650,000) 1.000 $(650,000) $85,000 1.000 $10,500 0.893 $(77,000) 4.564 $39,000 $42,000 3.605 0.452 85,000 9,377 (351,428) 140,595 18,984 $(747,472) * Book value of old trucks $120,000 Less sale price (above) 85,000 Loss on the sale $ 35,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 852 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-5 (continued) Items and Computations Keep the old trucks: Repairs needed Annual cash operating costs Depreciation deductions Salvage value of the old trucks Net present value Net present value in favor of keeping the old trucks Year(s) 1-7 1-2 (1) Amount (2) Tax Effect (1)×(2) After-Tax Cash 12% Flows Factor Present Value of Cash Flows $(170,000) – 0.30 $(119,000) 0.893 $(106,267) $(200,000) – 0.30 $(140,000) 4.564 (638,960) $60,000 0.30 $18,000 1.690 30,420 $15,000 – 0.30 $10,500 0.452 4,746 $(710,061) $ 37,411 © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14C 853 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-5 (continued) The solution by the incremental-cost approach below computes the net advantage (or disadvantage) of investing in the new trucks versus keeping the old trucks Items and Computations Investment in the new trucks Repairs avoided on the old truck Cash from the sale of the old trucks: Sale price received Tax savings from loss on sale Savings in annual cash operating costs ($200,000 – $110,000) Depreciation deductions: Depreciation on new trucks Depreciation forgone on old trucks Difference in salvage value in seven years ($60,000 – $15,000) Net present value Year(s) Now (1) Amount (2) Tax Effect $(650,000) — $170,000 – 0.30 Now $85,000 $35,000 1-7 $90,000 – 0.30 1-5 1-2 $130,000 $(60,000) — 0.30 0.30 0.30 $45,000 – 0.30 (1)×(2) After-Tax 12% Cash Flows Factor $(650,000) $119,000 Present Value of Cash Flows 1.000 $(650,000) 0.893 106,267 $85,000 $10,500 1.000 0.893 85,000 9,377 $63,000 4.564 287,532 $39,000 $(18,000) 3.605 1.690 140,595 (30,420) $31,500 0.452 14,238 $ (37,411) Because the net present value of investing in the new trucks rather than keeping the old trucks is negative, the new trucks should not be purchased © The McGraw-Hill Companies, Inc., 2010 All rights reserved 854 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-6 (45 minutes) Items and Computations Alternative 1: Investment in the bonds Interest on the bonds (10% × $225,000) Maturity of the bonds Net present value (1)×(2) After-Tax 8% Cash Flows Factor Year(s) (1) Amount (2) Tax Effect Now $(225,000) — $(225,000) 1-12 12 $22,500 $225,000 – 0.40 — $13,500 $225,000 Present Value of Cash Flows 1.000 $(225,000) 7.536 0.397 101,736 89,325 $ (33,939) © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Appendix 14C 855 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 14C-6 (continued) Items and Computations Alternative 2: Investment in the business Annual net cash receipts ($850,000 – $780,000 = $70,000) Depreciation deductions: Year 1: 14.3% of $80,000 Year 2: 24.5% of $80,000 Year 3: 17.5% of $80,000 Year 4: 12.5% of $80,000 Year 5: 8.9% of $80,000 Year 6: 8.9% of $80,000 Year 7: 8.9% of $80,000 Year 8: 4.5% of $80,000 Payment to break the lease Recovery of working capital ($225,000 – $80,000 = $145,000) Net present value Net present value in favor of alternative Year(s) (1) Amount (2) Tax Effect Now $(225,000) — (1)×(2) After-Tax Cash 8% Flows Factor $(225,000) 1.000 $(225,000) 1-12 $70,000 – 0.40 $42,000 7.536 12 $11,440 0.40 $19,600 0.40 $14,000 0.40 $10,000 0.40 $7,120 0.40 $7,120 0.40 $7,120 0.40 $3,600 0.40 $(2,000) – 0.40 $4,576 $7,840 $5,600 $4,000 $2,848 $2,848 $2,848 $1,440 $(1,200) 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.397 12 $145,000 — Present Value of Cash Flows $145,000 0.397 316,512 4,237 6,719 4,446 2,940 1,939 1,794 1,660 778 (476) 57,565 $173,114 $207,053 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 856 Managerial Accounting, 13th Edition ... return, as shown by its negative net present value © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 14 797 To download more slides, ebook, solutions and test... investment (as shown by the project profitability index) © The McGraw-Hill Companies, Inc., 2010 All rights reserved 806 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and... investment (as shown by the project profitability index) © The McGraw-Hill Companies, Inc., 2010 All rights reserved 808 Managerial Accounting, 13th Edition To download more slides, ebook, solutions and