Capital Budgeting Decisions

Chapter 12: The Capital Budgeting Decision
Chapter 12
The Capital Budgeting Decision
Discussion Questions
12-1.
What are the important administrative considerations in the capital budgeting

process?
Important administrative considerations relate to: the search for and discovery
of investment opportunities, the collection of data, the evaluation of projects,
and the reevaluation of prior decisions.
12-2.
Why does capital budgeting rely on analysis of cash flows rather than on net
income?
Cash flow rather than net income is used in capital budgeting analysis because
the primary concern is with the amount of actual dollars generated. For
example, depreciation is subtracted out in arriving at net income, but this noncash deduction should be added back in to determine cash flow or actual dollars
generated.
12-3.
What are the weaknesses of the payback method?

The weaknesses of the payback method are:
a. There is no consideration of inflows after payback is reached.
b. The concept fails to consider the time value of money.
12-4.
What is normally used as the discount rate in the net present value method?
The cost of capital as determined in Chapter 11.
12-5.
What does the term mutually exclusive investments mean?

The selection of one investment precludes the selection of other alternative
investments because the investments compete with one another. For example if
a company is going to build one new plant and is considering 5 cities, one city
will win and the others will lose.
12-6.
How does the modified internal rate of return include concepts from both the
traditional internal rate of return and the net present value methods?
The modified internal rate of return calls for the determination of the interest
rate that equates future inflows to the investment as does the traditional internal
rate or return. However, it incorporates the reinvestment rate assumption of the
net present value method. That is that inflows are reinvested at the cost of
capital.
12-1
12-7.
If a corporation has projects that will earn more than the cost of capital, should
it ration capital?
From a purely economic viewpoint, a firm should not ration capital. The firm
should be able to find additional funds and increases its overall profitability and
wealth through accepting investments to the point where marginal return equals
marginal cost.
12-8.
What is the net present value profile? What three points should be determined
to graph the profile?
The net present value profile allows for the graphic portrayal of the net present
value of a project at different discount rates. Net present values are shown along
the vertical axis and discount rates are shown along the horizontal axis.
The points that must be determined to graph the profile are:
a. The net present value at zero discount rate.
b. The net present value as determined by a normal discount rate.
c. The internal rate of return for the investment.
12-9.
How does an asset's ADR (asset depreciation range) relate to its MACRS
category?
The ADR represents the asset depreciation range or the expected physical life of
the asset. Generally, the midpoint of the range or life is utilized. The longer the
ADR midpoint, the longer the MACRS category in which the asset is placed.
However, most assets can still be written off more rapidly than the midpoint of
the ADR. For example, assets with ADR midpoints of 10 years to 15 years can
be placed in the 7-year MACRS category for depreciation purposes.
Chapter 12
Problems
1.
Cash flow (LO2) Assume a corporation has earnings before depreciation and taxes of
$100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its
cash flow using the format below.
12-2
Earnings before depreciation and taxes

Depreciation
Earnings before taxes
Taxes @ 30%
Earnings after taxes
Depreciation
_____
_____
_____
_____
_____
_____
12-1. Solution:
Depreciation
Taxes @ 30%
Depreciation
Cash flow
2.
$100,000
50,000
50,000
15,000
35,000
+ 50,000
$ 85,000
Cash flow (LO2)

a. In problem 1, how much would cash flow be if there were only $10,000 in
depreciation? All other factors are the same.
b.
How much cash flow is lost due to the reduced depreciation between Problems
1 and 2a?
12-2. Solution:
a. Earnings before depreciation and taxes
Depreciation
Taxes @ 30%
Depreciation
Cash flow
$100,000
10,000
90,000
27,000
63,000
+ 10,000
$ 73,000
b. Cash flow (problem 1)

Cash flow (problem 2a)
$ 85,000
73,000
12-3
Difference in cash flow

3.
$ 12,000
Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $500,000
and no depreciation. It is in a 40 percent tax bracket.
a.
Compute its cash flow.
b.
Assume it has $500,000 in depreciation. Recompute its cash flow.
c.
How large a cash flow benefit did the depreciation provide?
12-3. Solution:
Depreciation
Taxes @ 40%
Depreciation
Cash flow
$ 500,000
0
500,000
200,000
300,000
0
$300,000
b. Earnings before depreciation and taxes

Depreciation
Taxes @ 40%
Depreciation
Cash flow
$500,000
500,000
0
0
0
500,000
$500,000
c. $500,000- $300,000 = $200,000 or (.40 x $500,000).
12-4
4.
Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $400,000
and depreciation of $100,000.
a.
If it is in a 35 tax bracket, compute its cash flow.
b.
If it is in a 20 tax bracket, compute its cash flow.
12-4. Solution:
5.

Depreciation
Taxes @ 35%
Depreciation
Cash flow
$400,000
100,000
300,000
105,000
195,000
+100,000
$295,000
b. Earnings before depreciation + taxes

Depreciation
Taxes @ 20%
Depreciation
Cash flow
$400,000
100,000
300,000
60,000
240,000
+100,000
340,000
Cash flow versus earnings (LO2) A1 Quick, the president of a New York Stock
Exchange-listed firm, is very short term oriented and interested in the immediate
consequences of his decisions. Assume a project that will provide an increase of $2 million
in cash flow because of favorable tax consequences, but carries a two-cent decline in
earning per share because of a write-off against first quarter earnings. What decision might
Mr. Quick make?
12-5. Solution:
12-5
A1 Quick
Being short term oriented, he may make the mistake of
turning down the project even though it will increase cash flow
because of his fear of investors negative reaction to the more
widely reported quarterly decline in earnings per share. Even
though this decline will be temporary, investors might interpret it
as a negative signal.
6.
Payback method (LO3) Assume a $200,000 investment and the following cash flows for
two products:
Year
1
2
3
4
Product X
$60,000
90,000
50,000
40,000
Product Y
$40,000
70,000
80,000
20,000
Which alternatives would you select under the payback method?
12-6. Solution:
Payback for Product X
$200,000 60,000
140,000 90,000
50,000 50,000
Payback for Product Y
1 year
2 years
3 years
$200,000 40,000
160,000 70,000
90,000 80,000
10,000/20,000
1 Year
2 years
3 years
.5 years
Payback Product X = 3.00 years

Payback Product Y =3.50 years
Product X would be selected because of the faster payback.
12-6
7.
Payback method (LO3) Assume a $50,000 investment and the following cash flows for
two alternatives.
Year
1.................
2.................
3.................
4.................
5.................
Investment A
$10,000
11,000
13,000
16,000
30,000
Investment B
$20,000
25,000
15,000
Which alternative would you select under the payback method?
12-7. Solution:
Payback for Investment A
Payback for Investment B
$50,000 $10,000
40,000 11,000
29,000 13,000
16,000 16,000
$50,000 $20,000
30,000 25,000
5,000/15,000
1 year
2 years
3 years
4 years
1 year
2 years
.33 years
Payback Investment A = 4.00 years

Payback Investment B = 2.33 years
Investment B would be selected because of the faster payback.
8.
Payback method (LO3) Referring back to Problem 7, if the inflow in the fifth year for
Investment A were $30,000,000 instead of $30,000, would your answer change under the
payback method?
12-8. Solution:
The $30,000,000 inflow would still leave the payback period for
Investment A at 4 years. It would remain inferior to Investment
B under the payback method.
12-7
9.
Payback method (LO3) The Short-Line Railroad is considering a $100,000 investment in

either of two companies. The cash flows are as follows:
Year
1...................
2...................
3...................
410.............
a.
b.
Electric Co.
$70,000
15,000
15,000
10,000
Water Works
$15,000
15,000
70,000
10,000
Using the payback method, what will the decision be?

Explain why the answer in part a can be misleading.
12-9. Solution:
Short-Line Railroad
a.
Payback for Electric Co.
$100,000 $70,000
30,000 15,000
15,000 15,000
Payback for Water Works
1 year $100,000 $15,000

2 years
85,000 15,000
3 years
70,000 70,000
1 year
2 years
3 years
Payback (Electric Co.) = 3 years

Payback (Water Works) = 3 years
b. The answer in part a) is misleading because the two
investments seem to be equal with the same payback period
of three years. Nevertheless, the Electric Co. is a superior
investment because it covers large cash flows in the first
year, while the large recovery for Water Works is not until the
third year. The problem is that the payback method does not
consider the time value of money.
12-8
10.
Payback and net present value (LO3 & 4) Diaz Camera Company is considering two
investments, both of which cost $10,000. The cash flows are as follows:
Year
1.......................
2.......................
3.......................
a.
b.
c.
Project A
$6,000
4,000
3,000
Project B
$5,000
3,000
8,000
Which of the two projects should be chosen based on the payback method?
Which of the two projects should be chosen based on the net present value method?
Assume a cost of capital of 10 percent.
Should a firm normally have more confidence in answer a or answer b?
12-10. Solution:
Diaz Camera Company
a. Payback Method
Payback for Project A
Payback for Project B
2 years
2 years
Under the Payback Method, you should select Project A

because of the shorter payback period.
b. Net Present Value Method
Project A
Year
1
2
3
Cash Flow
PVIF at 10%
Present Value
$6,000
$4,000
$3,000
.909
.826
.751
$ 5,454
$ 3,304
$ 2,253
Present Value of Inflows

Present Value of Outflows
Net Present Value
12-9
$11,011
10,000
$ 1,011
12-10. (Continued)
Project B
Year
1
2
3
Cash Flow
PVIF at 10%
Present Value
$5,000
$3,000
$8,000
.909
.826
.751
$ 4,545
$ 2,478
$ 6,008

Present Value of Outflows
Net Present Value
$13,031
10,000
$ 3,031
Under the net present value method, you should select

Project B because of the higher net present value.
c. A company should normally have more confidence in answer
b because the net present value considers all inflows as well
as the time value of money. The large late inflow for Project
B was partially ignored under the payback method.
11.
Internal rate of return (LO4) You buy a new piece of equipment for $11,778, and you
receive a cash inflow of $2,000 per year for 10 years. What is the internal rate of return?
12-11. Solution:
Appendix D
PVIFA
$11, 778
5.889
$2, 000
IRR = 11%
For n = 10, we find 5.889 under the 11% column.
12-10
12.
Internal rate of return (LO4) Kings Department Store is contemplating the purchase of a
new machine at a cost of $13,869. The machine will provide $3,000 per year in cash flow
for six years. Kings has a cost of capital of 12 percent. Using the internal rate of return
method, evaluate this project and indicate whether it should be undertaken.
12-12. Solution:
Kings Department Store
Appendix D
PVIFA = $13,869/$3,000 = 4.623
IRR = 8%
For n = 6, we find 4.623 under the 8% column.
The machine should not be purchased since its return is less
than the 12 percent cost of capital.
13.
Internal rate of return (LO4) Home Security Systems is analyzing the purchase of
manufacturing equipment that will cost $40,000. The annual cash inflows for the next three
years will be:
Year
1..........................
2..........................
3..........................
a.
b.
Cash Flow
$20,000
18,000
13,000
Determine the internal rate of return using interpolation.

With a cost of capital of 12 percent, should the machine be purchased?
12-13. Solution:
12-11
Home Security Systems

a. Step 1 Average the inflows.
$20, 000
18, 000
13, 000
$51, 000 3 $17, 000
Step 2 Divide the inflows by the assumed annuity in Step 1.
Investment $40, 000
2.353
Annuity
17, 000
Step 3 Go to Appendix D for the 1st approximation.
The value in Step 2 (for n = 3) falls between
13% and 14%.
Step 4 Try a first approximation of discounting back the
inflows. Because the inflows are biased toward
the early years, we will use the higher rate of 14%.
12-13. (Continued)
Year
1
2
3
Cash Flow
$20,000
$18,000
$13,000
PVIF at 14% Present Value

.877
$17,540
.769
$13,842
.675
$ 8,775
$40,157
Step 5 Since the NPV is slightly over $40,000, we need to

try a higher rate. We will try 15%.
12-12
Year
1
2
3
Cash Flow
$20,000
$18,000
$13,000

.870
$17,400
.756
$13,608
.658
$ 8,554
$39,562
Because the NPV is now below $40,000, we know the IRR

is between 14% and 15%. We will interpolate.
$40,157...........PV @ 14%
39,562...........PV @ 15%
$ 595
$40,157.............PV @ 14%
40,000.............Cost
$ 157
14% + ($157/$595) (1%) = .264

14% + .264 (1%) = 14.264% IRR
The IRR is 14.264%
If the student skipped from 14% to 16%, the calculations to
find the IRR would be as follows:
Year
1
2
3
Cash Flow
$20,000
$18,000
$13,000
12-13

.862
$ 17,240
.743
$ 13,374
.641
$ 8,333
$ 38,947
12-13. (Continued)
$40,157...........PV @ 14%
$40,157.............PV @ 14%
38,947...........PV @ 16%
40,000.............Cost
$ 1,210
157
14% + ($157/$1,210) (2%) = .13 (2%)

14% + (.13) (2%) = 14.260%
This answer is very close to the previous answer, the
difference is due to rounding and that the differences
between the numbers in the table are not linear.
b. Since the IRR of 14.264% (or 14.260%) is greater than the
cost of capital of 12%, the project should be accepted.
14.
Net present value method (LO4) Altman Hydraulic Corporation will invest $160,000 in a
project that will produce the cash flow shown below. The cost of capital is 11 percent.
Should the project be undertaken? Use the net present value method. (Note that the third
years cash flow is negative.)
Year
1............
2............
3............
4............
5............
Cash Flow
$54,000
66,000
(60,000)
57,000
120,000
12-14. Solution:
Altman Hydraulic Corporation
12-14
Year
1
2
3
4
5
Cash Flow
$54,000
$66,000
(60,000)
57,000
120,000

.901
$ 48,654
.812
$ 53,592
.731
(43,860)
.659
37,563
.593
71,160
Present value of inflows

Present value of outflows
Net present value
$167,109
160,000
$ 7,109
The net present value is positive and the project should be

undertaken.
15.
Net present value method (LO4) Hamilton Control Systems will invest $90,000 in a
temporary project that will generate the following cash inflows for the next three years.
Year
1............
2............
3............
Cash Flow
$23,000
38,000
60,000
The firm will be required to spend $15,000 to close down the project at the end of the three
years. If the cost of capital is 10 percent, should the investment be undertaken? Use the net
present value method.
12-15. Solution:
Hamilton Control Systems
Present Value of inflows
12-15
Year
1
2
3
Cash Flow PVIF at 10% Present Value

$23,000
.909
$ 20,907
38,000
.826
31,388
60,000
.751
45,060
$ 97,355
Present Value of outflows

0
3
$90,000
15,000
1.000
.751
Present Value of inflows

Present Value of outflows
Net present value
16.
$ 90,000
11,265
$101,265
$97,355
101,265
($3,910)
Net present value method (LO4) Cellular Labs will invest $150,000 in a project that will
not begin to produce returns until after the third year. From the end of the 3rd year until the
end of the 12th year (10 periods), the annual cash flow will be $40,000. If the cost of
capital is 12 percent, should this project be undertaken?
12-16. Solution:
Cellular Labs
Find the Present Value of a Deferred Annuity
A
= $40,000, n = 10, i = 12%
PVA
= A PVIFA (Appendix D)
PVA
= $40,000 5.650 = $226,000
Discount from Beginning of the third period (end of second

period to present):
12-16
FV
= $226,000, n = 2, i = 12%
PV
= FV PVIF (Appendix B)
PV
= $226,000 .797 = $180,122

Net present value
$180,122
150,000
$ 30,122
The net present value is positive and the project should be

undertaken.
17.
Net present value and internal rate of return methods (LO4) The Hudson Corporation
makes an investment of $14,400 that provides the following cash flow:
Year
1.................
2.................
3.................
a.
b.
c.
Cash Flow
$ 7,000
7,000
4,000
What is the net present value at an 11 percent discount rate?

What is the internal rate of return? Use the interpolation procedure shown in this
chapter.
In this problem would you make the same decision under both parts a and b?
12-17. Solution:
Hudson Corporation
12-17
a. Net Present Value

Year
1
2
3
Cash Flow
$7,000
7,000
4,000
11% PVIF
.901
.812
.731

Net present value
Present Value
$ 6,307
5,684
2,924
$14,915
14,400
$ 515
b. Internal Rate of Return

We will average the inflows to arrive at an assumed annuity
value.
$7,000
7,000
4,000
$18,000/3 = $6,000
12-17. (Continued)
We divide the investment by the assumed annuity value.
$14,400
2.4
6,000
PVIFA
Using Appendix D for n = 3, the first approximation appears

to fall between 12% and 13%. Since the heavy inflows are in
the early years, we will try 13 percent.
Year
1
Cash Flow 13% PVIF

$7,000
.885
12-18
Present Value
$ 6,195
2
3
7,000
.783
4,000
.693
5,481
2,772
$14,448
Since 13% is not high enough to get $14,400 as the present

value, we will try 15% (We could have only gone up to 14%,
but we wanted to be sure to include $14,400 in this calculation.
Of course, students who use 14% are doing fine).
Year
1
2
3
Cash Flow 15%PVIF

$7,000
.870
7,000
.756
4,000
.658
Present Value
$ 6,090
5,292
2,632
$14,014
The correct answer must fall between 13% and 15%. We

interpolate.
$14,448...........PV @ 13%
14,014...........PV @ 15%
$ 434
$14,448.............PV @ 13%
14,400.............Cost
$
48
12-17. (Continued)
13%
$48
(2%) 13% .11 (2%) 13% .22% 13.22%
$434
As an alternative answer, students who use 14% as the second

trial and error rate will show to following:
Year
1
2
3
Cash Flow 14%PVIF

$7,000
.877
7,000
.769
4,000
.675
12-19
Present Value
$ 6,139
5,383
2,700
$14,222
The correct answer falls between 13% and 14%. We

interpolate.
$14,448
4,222
226
13%
PV @ 13%
PV @ 14%
$14,448
14,400
$
48
PV @ 13%
Cost
$48
(1%) 13% .21 (1%) 13% .21% 13.21%
$226
c. Yes, both the NPV is greater than 0 and the IRR is greater
than the cost of capital.
18.
Net present value and internal rate of return methods (LO4) The Pan American
Bottling Co. is considering the purchase of a new machine that would increase the speed of
bottling and save money. The net cost of this machine is $45,000. The annual cash flows
have the following projections.
Year
1............
2............
3............
4............
5............
a.
b.
c.
Cash Flow
$15,000
20,000
25,000
10,000
5,000
If the cost of capital is 10 percent, what is the net present value of selecting a new
machine?
What is the internal rate of return?
Should the project be accepted? Why?
12-18. Solution:
Pan American Bottling Co.
a. Net Present Value
Year
1
2
Cash Flow 10% PVIF

$15,000
.909
20,000
.826
12-20
Present Value
$13,635
16,520
3
4
5
25,000
10,000
5,000
.751
.683
.621

Net present value
18,775
6,830
3,105
$58,865
45,000
$13,865
12-18. (Continued)
b. Internal Rate of Return
We will average the inflows to arrive at an assumed annuity.
$15,000
20,000
25,000
10,000
5,000
$75,000/5 = $15,000
We divide the investment by the assumed annuity value.
$45, 000
3 PVIFA
$15, 000
Using Appendix D for n = 5, 20% appears to be a reasonable
first approximation (2.991). We try 20%.
Year
1
2
3
4
5
Cash Flow 20% PVIF

$15,000
.833
20,000
.694
25,000
.579
10,000
.482
5,000
.402
12-21
Present Value
$12,495
13,880
14,475
4,820
2,010
$47,680
Since 20% is not high enough, we try the next highest rate
at 25%.
Year
1
2
3
4
5
Cash Flow 25% PVIF

$15,000
.800
20,000
.640
25,000
.512
10,000
.410
5,000
.328
Present Value
$12,000
12,800
12,800
4,100
1,640
$43,340
12-18. (Continued)
The correct answer must fall between 20% and 25%. We
interpolate.
$47,680...........PV @ 20%
43,340............PV @ 25%
$ 4,340
20%
$47,680.............PV @ 20%
45,000.............Cost
$ 2,680
$2, 680
(5%) 20% .62 (5%) 20% 3.10% 23.10%
$4,340
c. The project should be accepted because the net present value

is positive and the IRR exceeds the cost of capital.
19.
Use of profitability index (LO4) You are asked to evaluate the following two projects for
the Norton Corporation. Using the net present value method combined with the
profitability index approach described in footnote 2 of this chapter, which project would
you select? Use a discount rate of 10 percent.
12-22
Project X (Videotapes
of the Weather Report)
($10,000 Investment)
Year
1.........................
Project Y (Slow-Motion
Replays of Commercials)
($30,000 investment)
Cash Flow
$5,000
Year
1...................................
Cash Flow
$15,000
2.........................
3,000
2...................................
8,000
3.........................
4,000
3...................................
9,000
4.........................
3,600
4...................................
11,000
12-19. Solution:
Norton Corporation
NPV for Project X
Year
1
2
3
4
Cash Flow PVIF at 10%

$5,000
.909
3,000
.826
4,000
.751
3,600
.683
Present Value
$ 4,545
2,478
3,004
2,459

$12,486
Present value of outflows (Cost) 10,000
Net present value
$ 2,486
Pr ofitability index (X)
Pr esent value of outflows
$12, 486
1.2486
$10, 000
12-23
NPV for Project Y

Year
1
2
3
4
Cash Flow PVIF at 10%

$15,000
.909
8,000
.826
9,000
.751
11,000
.683
Present Value
$ 13,635
6,608
6,759
7,513

Present value of outflows (Cost)
Net present value
Pr ofitability index (Y)
$34,515
30,000
$ 4,515

Pr esent value of outflows
$34,515
1.1505
$30, 000
You should select Project X because it has the higher

profitability index. This is true in spite of the fact that it has a
lower net present value. The profitability index may be
appropriate when you have different size investments.
20.
Reinvestment rate assumption in capital budgeting (LO4) Turner Video will invest
$48,500 in a project. The firms cost of capital is 9 percent. The investment will provide the
following inflows.
Year
1.................
2.................
3.................
4.................
5.................
Inflow
$10,000
12,000
16,000
20,000
24,000
The internal rate of return is 14 percent.
12-24
a.
b.
c.
If the reinvestment assumption of the net present value method is used, what will be
the total value of the inflows after five years? (Assume the inflows come at the end of
each year.)
If the reinvestment assumption of the internal rate of return method is used, what will
be the total value of the inflows after five years?
Generally is one investment assumption likely to be better than another?
12-20. Solution:
Turner Video
a. Reinvestment assumption of NPV
Year
Value
1
2
3
4
5
Inflows
Rate
No. of
Periods
$10,000
12,000
16,000
20,000
24,000
9%
9%
9%
9%
4
3
2
1
0
1.412
1.295
1.188
1.090
1.000
$14,120
15,540
19,008
21,800
24,000
$94,468
1.689
1.482
1.300
1.140
1.000
$ 16,890
17,784
20,800
22,800
24,000
12-20. (Continued)
b. Reinvestment assumption of IRR
Year
Value
1
2
3
4
5
Inflows
Rate
No. of
Periods
$10,000
12,000
16,000
20,000
24,000
14%
14%
14%
14%
4
3
2
1
0
12-25
$102,274
12-26
c. No. However, for investments with a very high IRR, it may

be unrealistic to assume that reinvestment can take place at
an equally high rate. The net present value method makes the
more conservative assumption of reinvestment at the cost of
capital.
21.
Modified internal rate of return (LO4) The Caffeine Coffee Company uses the modified
internal rate of return. The firm has a cost of capital of 12 percent. The project being
analyzed is as follows ($27,000 investment):
Year
1............
2............
3............
a.
b.
Cash Flow
$15,000
12,000
9,000
What is the modified internal rate of return? An approximation from Appendix B is

adequate. (You do not need to interpolate.)
Assume the traditional internal rate of return on the investment is 17.5 percent.
Explain why your answer in part a would be lower.
12-21. Solution:
Caffeine Coffee Company
Terminal Value (end of year 3)
a.
Year 1
Year 2
Year 3
Period of
Growth
$15,000
2
12,000
1
9,000
0
FV Factor
(12%)
(Appendix A)
1.254
1.120
1.000
Terminal Value
Future
Value
$18,810
13,440
9,000
$41,250
To determine the modified internal rate of return, calculate

the yield on the investment.
12-27
PVIF
=
PV
(Appendix B)
FV
$27, 000
.655
41, 250
Use Appendix B for 3 periods, the answer is approximately

15 percent (.658).
12-21. (Continued)
b. The answer is lower than 17 percent under the Modified IRR
because inflows are reinvested at the cost of capital of
12 percent. Under the traditional IRR, inflows are reinvested
at the internal rate of return of 17.5 percent, which leads to
a higher terminal value.
22.
Capital rationing and mutually exclusive investments (LO4) The Suboptimal Glass
Company uses a process of capital rationing in its decision making. The firms cost of
capital is 13 percent. It will only invest only $60,000 this year. It has determined the
internal rate of return for each of the following projects.
Project
A.....................
B.....................
C.....................
D.....................
E......................
F......................
G.....................
a.
b.
Project Size
$10,000
30,000
25,000
10,000
10,000
20,000
15,000
Internal Rate of
Return
15%
14
16.5
17
23
11
16
Pick out the projects that the firm should accept.

If Projects D and E are mutually exclusive, how would that affect your overall
answer? That is, which projects would you accept in spending the $60,000?
12-28
12-22. Solution:
Suboptimal Glass Company
You should rank the investments in terms of IRR.
Project
E
D
C
G
A
B
F
IRR
23%
17
16.5
16
15
14
11
Project Size
$10,000
10,000
25,000
15,000
10,000
30,000
20,000
Total Budget
$ 10,000
20,000
45,000
60,000
70,000
100,000
120,000
a. Because of capital rationing, only $60,000 worth of projects

can be accepted. The four projects to accept are E, D, C and
G. Projects A and B provide positive benefits also, but cannot
be undertaken under capital rationing.
b. If Projects D and E are mutually exclusive, you would select
Project E in preference to D. You would then include Project
A with the freed up funds. In summary, you would accept E,
C, G and A. The last Project would replace D and is of the
same $10,000 magnitude.
23.
Net present value profile (LO4) Keller Construction is considering two new investments.
Project E calls for the purchase of earthmoving equipment. Project H represents an
investment in a hydraulic lift. Keller wishes to use a net present value profile in comparing
the projects. The investment and cash flow patterns are as follows:
12-29
Project E
Project H
($20,000 Investment)
($20,000 investment)
Year
Cash Flow
1...........................
$ 5,000
2...........................
6,000
3...........................
7.000
4...........................
10,000
a.
b.
c.
d.
e.
Year
1..................................
2..................................
3..................................
Cash Flow
$16,000
5,000
4,000
Determine the net present value of the projects based on a zero discount rate.
Determine the net present value of the projects based on a 9 percent discount rate.
The internal rate of return on Project E is 13.25 percent, and the internal rate of return
on Project H is 16.30 percent. Graph a net present value profile for the two
investments similar to Figure 12-3. (Use a scale up to $8,000 on the vertical axis, with
$2,000 increments. Use a scale up to 20 percent on the horizontal axis, with
5 percent increments.)
If the two projects are not mutually exclusive, what would your acceptance or
rejection decision be if the cost of capital (discount rate) is 8 percent? (Use the net
present value profile for your decision; no actual numbers are necessary.)
If the two projects are mutually exclusive (the selection of one precludes the selection
of the other), what would be your decision if the cost of capital is (1) 6 percent,
(2) 13 percent, (3) 18 percent? Once again, use the net present value profile for your
answer.
12-23. Solution:
Keller Construction Company
a. Zero discount rate
Project E
Inflows
8,000 = ($5,000 + $6,000 + $7,000 + $10,000)
Outflow
$20,000
Project H
Inflows
Outflow
$ 5,000 = ($16,000 + $5,000 + $4,000) $20,000
b. 9% discount rate
12-30
Project E
Year
1
2
3
4
Cash Flow
$ 5,000
6,000
7,000
10,000
PVIF at 9%
.917
.842
.772
.708

Net present value
Present Value
$ 4,585
5,052
5,404
7,080
$22,121
20,000
$ 2,121
12-23. (Continued)
Project H
Year
1
2
3
Cash Flow
$16,000
5,000
4,000
PVIF at 9%
.917
.842
.772

Net present value
12-31
Present Value
$14,672
4,210
3,088
$21,970
20,000
$ 1,970
c. Net Present Value Profile

Net present value
$8,000
Project E
6,000
4,000
2,000
Project H
IRRH = 16.30%
0
5%
10%
15%
20%
IRRC = 13.25%
Discount rate (%)
12-23. (Continued)
d. Since the projects are not mutually exclusive, they both can
be selected if they have a positive net present value. At a 9%
cost of capital, they should both be accepted. As a side note,
we can see Project E is superior to Project H.
e. With mutually exclusive projects, only one can be accepted.
Of course, that project must still have a positive net present
value. Based on the visual evidence, we see:
(i) 6% cost of capitalselect Project E
(ii) 13% cost of capitalselect Project H
12-32
(iii) Do not select either project
12-33
24.
Net present value profile (LO4) Davis Chili Company is considering an investment of
$15,000, which produces the following inflows:
Year
1.................
2.................
3.................
Cash Flow
$8,000
7,000
4,000
You are going to use the net present value profile to approximate the value for the internal
rate of return. Please follow these steps:
a.
Determine the net present value of the project based on a zero discount rate.
b.
Determine the net present value of the project based on a 10 percent discount rate.
c.
Determine the net present value of the project based on a 20 percent discount rate
(it will be negative).
d.
Draw a net present value profile for the investment and observe the discount rate at
which the net present value is zero. This is an approximation of the internal rate of
return based on the interpolation procedure presented in this chapter. Compare your
answer in parts d and e.
e.
Actually compute the internal rate of return based on the interpolation procedure
presented in this chapter. Compare your answers in parts d and e.
12-24. Solution:
Davis Chili Company
a. NPV @ 0% discount rate
Inflows
Outflow
$4,000 = ($8,000 + $7,000 + $4,000) $15,000
b.
Year
1
2
3
Cash Flow
$8,000
7,000
4,000
PVIF at10%
.909
.826
.751

Net present value
12-34
Present Value
$ 7,272
5,782
3,004
$16,058
15,000
$ 1,058
12-24. (Continued)
c.
Year
1
2
3
Cash Flow
$8,000
7,000
4,000
PVIF at 20%
.833
.694
.579

Net present value
Present Value
$ 6,664
4,858
2,316
$13,838
15,000
($ 1,162)
d. Net Present Value Profile

Net present value
6,000
4,000
2,000
0
5%
10%
15%
Discount rate (%)
12-35
20%
12-24. (Continued)
e. The answer appears to be slightly above 14%. We will use
14% as the first approximation.
Year
1
2
3
Cash Flow
$8,000
7,000
4,000
PVIF at 14%
.877
.769
.675
Present Value
$ 7,016
5,383
2,700
$15,099
The second approximation is at 15%.

Year
1
2
3
Cash Flow
$8,000
7,000
4,000
PVIF at 15%
.870
.756
.658
Present Value
$ 6,960
5,292
2,632
$14,884
We interpolate between 14% and 15%.

$15,099
14,884
$ 215
PV @ 14%
PV @ 15%
$15,099
15,000
$ 99
PV @ 14%
Cost
14% + ($99/$215) (1%) = 14% + .46 = 14.46%

The interpolation value of 14.46% appears to be very close to
the graphically determined value in part d.
12-36
25.
MACRS depreciation and cash flow (LO2) Telstar Commumications is going to

purchase an asset for $300,000 that will produce $140,000 per year for the next four years
in earnings before depreciation and taxes. The asset will be depreciated using the three-year
MACRS depreciation schedule in Table 129 on page ___. (This represents four years of
depreciation based on the half-year convention.) The firm is in a 35 percent tax bracket. Fill
in the schedule below for the next four years.
Depreciation
Taxes
+ Depreciation
Cash flow
_____
_____
_____
_____
_____
_____
_____
12-25. Solution:
Telstar Communications Corporation
First determine annual depreciation.
Year
1
2
3
4
Depreciation
Base
$300,000
300,000
300,000
300,000
Percentage
Depreciation
(Table 12-9)
.333
.445
.148
.074
Annual
Depreciation
$ 99,900
133,500
44,400
22,200
$300,000
Then determine the annual cash flow. Earnings before

depreciation and taxes (EBDT) will be the same for each year,
but depreciation and cash flow will differ.
12-37
EBDT
D
EBT
T (35%)
EAT
+D
Cash Flow
26.
1
2
3
4
$140,000 $140,000 $140,000 $140,000
99,900 133,500
44,400
22,200
40,100
6,500
95,600 117,800
14,035
2,275
33,460
41,230
26,065
4,225
62,140
76,570
99,900 133,500
44,400
22,200
$125,965 $137,725 $106,540 $98,770
MACRS depreciation categories (LO4) Assume $60,000 is going to be invested in each

of the following assets. Using Tables 128 and 129, indicate the dollar amount of the first
years depreciation.
a.
Office furniture.
b.
Automobile.
c.
Electric and gas utility property.
d.
Sewage treatment plant.
12-26. Solution:
a. Office furniture Based on Table 12-8, this falls under
7-year MACRS depreciation. Then examining Table 12-9, the
first year depreciation rate is .143. Thus:
$60, 000 .143 $8,580
b. Automobile This falls under 5-year MACRS depreciation.
This first year depreciation rate is .200.
$60, 000 .200 $12, 000
c. Electric and gas utility property This falls under 20-year
MACRS depreciation. The first year depreciation rate is .038.
$60, 000 .038 $2, 280
12-38
d. Sewage treatment plant This falls under 15-year MACRS

depreciation. This first year depreciation rate is .050.
$60, 000 .050 $3, 000
27.
MACRS depreciation and net present value (LO4) The Summitt Petroleum Corporation
will purchase an asset that qualifies for three-year MACRS depreciation. The cost is
$80,000 and the asset will provide the following stream of earnings before depreciation and
taxes for the next four years:
Year 1...................
Year 2...................
Year 3...................
Year 4...................
$36,000
40,000
31,000
19,000
The firm is in a 35 percent tax bracket and has an 11 percent cost of capital. Should it
purchase the asset? Use the net present value method.
12-27. Solution:
Summit Petroleum Corporation
Year
1
2
3
4
Depreciation
Base
$80,000
80,000
80,000
80,000
Percentage
Depreciation
(Table 12-9)
.333
.445
.148
.074
Then determine the annual cash flow.
12-39
Annual
Depreciation
$26,640
35,600
11,840
5,920
$80,000
EBDT
D
EBT
T (35%)
EAT
+D
Cash Flow
1
$36,000
26,640
9,360
3,276
6,084
26,640
$32,724
2
$40,000
35,600
4,400
1,540
2,860
35,600
$38,460
3
$31,000
11,840
19,160
6,706
12,454
11,840
$24,294
4
$19,000
5,920
13,080
4,578
8,502
5,920
$14,422
12-27. (Continued)
Then determine the net present value.
Year
1
2
3
4
Cash Flow
(inflows)
$32,724
38,460
24,294
14,422
PVIF at 11%
.901
.812
.731
.659

Net present value
Present
Value
$29,484
31,230
17,759
9,504
$87,977
80,000
$ 7,977
The asset should be purchased based on the net present value.

28.
MACRS depreciation and net present value (LO4) Propulsion Labs will acquire new
equipment that falls under the five-year MACRS category. The cost is $200,000. If the
equipment is purchased, the following earnings before depreciation and taxes will be
generated for the next six years.
12-40
Year 1......................
Year 2......................
Year 3......................
Year 4......................
Year 5......................
Year 6......................
$75,000
70,000
55,000
35,000
25,000
21,000
The firm is in a 30 percent tax bracket and has a 14 percent cost of capital. Should
Propulsion Labs purchase the equipment? Use the net present value method.
12-28. Solution:
Propulsion Labs
Year
1
2
3
4
5
6
Depreciation
Base
$200,000
200,000
200,000
200,000
200,000
200,000
12-41
Percentage
Depreciation
(Table 12-9)
.200
.320
.192
.115
.115
.058
Annual
Depreciation
$ 40,000
64,000
38,400
23,000
23,000
11,600
$200,000
12-28. (Continued)
EBDT
D
EBT
T (30%)
EAT
+D
Cash Flow
1
$75,000
40,000
35,000
10,500
24,500
40,000
$64,500
2
3
4
5
6
$70,000 $55,000 $35,000 $25,000 $21,000
64,000 38,400 23,000 23,000 11,600
6,000 16,600 12,000
2,000
9,400
1,800
4,980
3,600
600
2,820
4,200 11,620
8,400
1,400
6,580
64,000 38,400 23,000 23,000 11,600
$68,200 $50,020 $31,400 $24,400 $18,180
Then determine the net present value.

Year
1
2
3
4
5
6
Cash Flow
(inflows)
$64,500
68,200
50,020
31,400
24,400
18,180
PVIF at 14%
.877
.769
.675
.592
.519
.456

Net present value
The equipment should not be purchased.
12-42
Present
Value
$ 56,567
52,446
33,764
18,589
12,664
8,290
$182,320
200,000
($ 17,680)
29.
MACRS depreciation and net present value (LO4) Universal Electronics is considering the
purchase of manufacturing equipment with a 10-year midpoint in its asset depreciation range
(ADR). Carefully refer to Table 128 to determine in what depreciation category the asset falls.
(Hint: It is not 10 years.) The asset will cost $90,000, and it will produce earnings before
depreciation and taxes of $32,000 per year for three years, and then $12,000 a year for seven
more years. The firm has a tax rate of 34 percent. With a cost of capital of 11 percent, should it
purchase the asset? Use the net present value method. In doing your analysis, if you have years
in which there is no depreciation, merely enter a zero for depreciation.
12-29. Solution:
Universal Electronics
Because the manufacturing equipment has a 10-year midpoint
of its asset depreciation range (ADR), it falls into the sevenyear MACRS category as indicated in Table 12-8.
Furthermore, we see that most types of manufacturing
equipment fall into the seven-year MACRS category.
With seven-year MACRS depreciation, the asset will be
depreciated over eight years (based on the half-year
convention). Also, we observe that the equipment will produce
earnings for 10 years, so in the last two years there will be no
depreciation write-off.
We first determine the annual depreciation.
Year
1
2
3
4
5
6
7
8
Depreciation
Base
$90,000
90,000
90,000
90,000
90,000
90,000
90,000
90,000
12-43
Percentage
Depreciation
(Table 12-9)
.143
.245
.175
.125
.089
.089
.089
.045
Annual
Depreciation
$12,870
22,050
15,750
11,250
8,010
8,010
8,010
4,050
$90,000
12-29. (Continued)
Annual Cash Flow
EBDT
D
EBT
T (34%)
EAT
+D
Cash Flow
1
$32,000
12,870
$19,130
6,504
$12,626
12,870
$25,496
2
$32,000
22,050
$ 9,950
3,383
$ 6,567
22,050
$28,617
3
$32,000
15,750
$16,250
5,525
$10,725
15,750
$26,475
4
$12,000
11,250
$ 750
255
$ 495
11,250
$11,745
5
$12,000
8,010
$ 3,990
1,357
$ 2,633
8,010
$10,643
12-44
6
$12,000
8,010
$ 3,990
1,375
$ 2,633
8,010
$10,643
7
8
9
10
$12,000 $12,000 $12,000 $12,000
8,010
4,050
0
0
$ 3,990 $ 7,950 $12,000 $12,000
1,375
2,703
4,080
4,080
$ 2,633 $ 5,247 $ 7,920 $ 7,920
8,010
4,050
0
0
$10,643 $ 9,297 $ 7,920 $ 7,920
12-29. (Continued)
Next determine the net present value.
Year
1
2
3
4
5
6
7
8
9
10
Cash Flow
(inflows)
$25,496
28,617
26,475
11,745
10,643
10,643
10,643
9,297
7,920
7,920
PVIF at 11%
.901
.812
.731
.659
.593
.535
.482
.434
.391
.352

Net present value
New asset should be purchased.
12-45
Present
Value
$ 22,972
23,237
19,353
7,740
6,311
5,694
5,130
4,035
3,097
2,788
$100,357
90,000
$ 10,357
30.
Working capital requirements in capital budgeting (LO4) The Bagwell Company has a
proposed contract with the First Military Base Facility of Texas. The initial investment in land
and equipment will be $90,000. Of this amount, $60,000 is subject to five-year MACRS
depreciation. The balance is in nondepreciable property (land). The contract covers six year
period. At the end of six years the nondepreciable assets will be sold for $30,000. The
depreciated assets will have zero resale value.
The contract will require an additional investment of $40,000 in working capital at the
beginning of the first year and, of this amount, $20,000 will be returned to the Bagwell
Company after six years.
The investment will produce $32,000 in income before depreciation and taxes for each of
the six years. The corporation is in a 35 percent tax bracket and has a 10 percent cost of capital.
Should the investment be undertaken? Use the net present value method.
12-30. Solution:
Bagwell Ball Bearing Company
Although there are some complicating features in the problem,
we are still comparing the present value of cash flows to the
total initial investment.
The initial investment is:
Non Depreciable Land......
Depreciable Machine
Working capital.................
Initial investment..............
$ 30,000
60,000
40,000
$130,000
In computed the present value of the cash flows, we first

determine annual depreciation based on a $60,000 depreciation
base.
12-46
12-30. (Continued)
Year
1
2
3
4
5
6
Depreciation
Base
$60,000
60,000
60,000
60,000
60,000
60,000
Percentage
Depreciation
(Table 12-9)
.200
.320
.192
.115
.115
.058
Annual
Depreciation
$12,000
19,200
11,520
6,900
6,900
3,480
$60,000
We then determine the annual cash flow. In addition to normal

cash flow from operations; we also consider the funds
generated in the sixth year from the sale of the nondepreciable
property (land) and from the recovery of working capital.
Annual Cash Flow
1
2
3
4
5
$32,000 $32,000 $32,000 $32,000 $32,000
12,000 19,200 11,520
6,900
6,900
20,000 12,800 20,480 25,100 25,100
7,000
4,480
7,168
8,785
8,785
13,000
8,320 13,312 16,315 16,315
12,000 19,200 11,520
6,900
6,900
EBDT
D
EBT
T (35%)
EAT
+D
Sale of nondepreciable
assets
+ Recovery
of working
capital
Cash Flow $25,000 $27,520 $24,832 $23,215 $23,215
12-47
6
$32,000
3,480
28,520
9,982
18,538
3,480
30,000
20,000
$72,018
12-30. (Continued)
We then determine the net present value.
Year
1
2
3
4
5
6
Cash Flow
(inflows)
PVIF at 10%
$ 25,000
.909
27,520
.826
24,832
.751
23,215
.683
23,215
.621
72,018
.564
Net present value
Present
Value
$ 22,725
22,732
18,649
15,856
14,417
40,618
$134,997
130,000
$ 4,997
The investment should be undertaken.

31.
Tax losses and gains in capital budgeting (LO2) An asset was purchased three years ago
for $120,000. It falls into the five-year category for MACRS depreciation. The firm is in a
35 percent tax bracket. Compute the following:
a.
Tax loss on the sale and the related tax benefit if the asset is sold now for $12,560.
b.
Gain and related tax on the sale if the asset is sold now for $51,060. (Refer to footnote 4 in
the chapter.)
12-31. Solution:
First determine the book value of the asset.
Depreciation
Year
Base
1
$120,000
2
120,000
3
120,000
Total depreciation to date
12-48
Percentage
Depreciation
(Table 12-9)
.200
.320
.192
Annual
Depreciation
$24,000
38,400
23,040
$85,440
Purchase price
Book value
$120,000
85,440
$ 34,560
a. $12,560 sales price

Book value
Sales price
Tax loss on the sale
$34,560
12,560
$22,000

Tax rate
Tax benefit
$22,000
35%
$ 7,700
b. $51,060 sales price

Sales price
Book value
Taxable gain
Tax rate
Tax obligation
32.
$51,060
34,560
16,500
35%
$ 5,775
Capital budgeting with cost of capital computation (LO5) DataPoint Engineering is considering
the purchase of a new piece of equipment for $220,000. It has an eight-year midpoint of its asset
depreciation range (ADR). It will require an additional initial investment of $120,000 in
nondepreciable working capital. Thirty thousand dollars of this investment will be recovered after
the sixth year and will provide additional cash flow for that year. Income before depreciation and
taxes for the next six years will be:
Year
1......................
2......................
3......................
4......................
5......................
6.....................
Amount
$170,000
150,000
120,000
105,000
90,000
80,000
12-49
The tax rate is 30 percent. The cost of capital must be computed based on
the following (round the final value to the nearest whole number):
Debt............................................................
Preferred stock............................................
Common equity (retained earnings)...........
a.
b.
c.
d.
Kd
Kp
Ke
Cost (aftertax)
6.5%
10.2
15.0
Weights
30%
10
60
Determine the annual depreciation schedule.

Determine annual cash flow. Include recovered working capital in the sixth year.
Determine the weighted average cost of capital.
Determine the net present value. Should DataPoint purchase the new equipment?
12-32. Solution:
DataPoint Engineering
a. An 8-year midpoint of the ADR leads to 5-year MACRS
depreciation.
Year
1
2
3
4
5
6
Depreciation
Base
$ 220,000
220,000
220,000
220,000
220,000
220,000
12-50
Percentage
Depreciation
(Table 12-9)
.200
.320
.192
.115
.115
.058
Annual
Depreciation
$ 44,000
70,400
42,240
25,300
25,300
12,760
$220,000
b.
EBDT
D
EBT
T (30%)
EAT
+D
+ Recovery of
working
capital
Cash
Flow
Annual Cash Flow

1
2
3
4
5
6
$170,000 $150,000 $120,000 $105,000 $90,000 $80,000
44,000
70,400
42,240
25,300 25,300 12,760
$126,000 $ 79,600 $ 77,760
79,700 $64,700 67,240
37,800
23,880
23,328
23,910 19,410 20,172
88,000
55,720
54,432
55,790 45,290 47,068
44,000
70,400
42,240
25,300 25,300 12,760
30,000
$132,20
0
$126,12
0
$ 96,672 $ 81,090 $70,590 $89,828
12-31. (Continued)
c.
Weighted Average Cost of Capital

Cost
(after tax) Weights Weighted
Debt
kd
Preferred stock
kp
Common equity
(retained earnings) ke
Weighted average
cost of Capital
12-51
6.5%
10.2%
30%
10%
1.95%
1.02%
15.0%
60%
9.00%
11.97%
d.
Net Present Value

Year
1
2
3
4
5
6
Cash Flow
(inflows)
PVIF at 12%
$132,200
.893
126,120
.797
96,672
.712
81,090
.636
70,590
.567
89,828
.507
*Present value of outflows
Net present value
Present
Value
$118,055
100,518
68,830
51,573
40,025
45,543
$424,544
340,000
$ 84,544
*This represents the $220,000 for the equipment plus the

$120,000 in initial working capital.
The net present value ($84,544) is positive and DataPoint
Engineering should purchase the equipment.
33.
Replacement decision analysis (LO4) Hercules Exercise Equipment Co. purchased a

computerized measuring device two years ago for $60,000. The equipment falls into the
five-year category for MACRS depreciation and can currently be sold for $23,800.
A new piece of equipment will cost $150,000. It also falls into the five-year category
for MACRS depreciation.
Assume the new equipment would provide the following stream of added cost savings
for the next six years.
Year
1............
2............
3............
4............
5............
6............
Cash Savings
$57,000
49,000
47,000
45,000
42,000
31,000
The firms tax rate is 35 percent and the cost of capital is 12 percent.
a.
What is the book value of the old equipment?
12-52
b.
What is the tax loss on the sale of the old equipment?
12-53
c.
d.
e.
f.
g.
h.
i.
j.
k.
What is the tax benefit from the sale?

What is the cash inflow from the sale of the old equipment?
What is the net cost of the new equipment? (Include the inflow from the sale of the
old equipment.)
Determine the depreciation schedule for the new equipment.
Determine the depreciation schedule for the remaining years of the old equipment.
Determine the incremental depreciation between the old and new equipment and the
related tax shield benefits.
Compute the aftertax benefits of the cost savings.
Add the depreciation tax shield benefits and the aftertax cost savings, and determine
the present value. (See Table 1217 as an example.)
Compare the present value of the incremental benefits (j) to the net cost of the new
equipment (e). Should the replacement be undertaken?
12-33. Solution:
Hercules Exercise Equipment Co.
a.
Year
1
2
Depreciation
Base
$60,000
60,000
Percentage
Depreciation
(Table 12-9)
.200
.320

Purchase price
Book value
$31,200
$60,000
31,200
$28,800
b. Book value
Sales price
$28,800
23,800
$ 5,000
c. Tax loss on the sale

Tax rate
$ 5,000
35%
12-54
Annual
Depreciation
$12,000
19,200
Tax benefit
$ 1,750
d. Sales price of the old equipment

Tax benefit from the sale
Cash inflow from the sale of the old equipment
$ 23,800
1,750
$ 25,550
e. Price of the new equipment

Cash inflow from the sale of the old equipment
Net cost of the new equipment
$150,000
25,550
$124,450
12-33. (Continued)
f.
Depreciation schedule on the new equipment.
Year
1
2
3
4
5
6
Depreciation
Base
$150,000
150,000
150,000
150,000
150,000
150,000
Percentage
Depreciation
(Table 12-9)
.200
.320
.192
.115
.115
.058
Annual
Depreciation
$ 30,000
48,000
28,800
17,250
17,250
8,700
$150,000
g. Depreciation schedule for the remaining years of the old

equipment.
12-55
Year*
1
2
3
4
Depreciation
Base
$60,000
60,000
60,000
60,000
Percentage
Depreciation
(Table 12-9)
.192
.115
.115
.058
Annual
Depreciation
$11,520
6,900
6,900
3,480
* The next four years represent the last four years on the old
equipment.
12-33. (Continued)
h. Incremental depreciation and tax shield benefits.
(1)
(2)
(3)
(4)
Depreciation Depreciation
on new
on old
Incremental
Equipment Equipment Depreciation
$30,000
$11,520
$18,480
48,000
6,900
41,100
28,800
6,900
21,900
17,250
3,480
13,770
17,250
17,250
8,700
8,700
Year
1
2
3
4
5
6
i.
Aftertax cost savings
12-56
(5)
Tax
Rate
.35
.35
.35
.35
.35
.35
(6)
Tax
Shield
Benefits
$ 6,468
14,385
7,665
4,819
6,038
3,045
Year
1
2
3
4
5
6
Savings
$57,000
49,000
47,000
45,000
42,000
31,000
After tax
(1-Tax Rate) Savings
.65
$37,050
.65
31,850
.65
30,550
.65
29,250
.65
27,300
.65
20,150
12-33. (Continued)
j.
Present value of the total incremental benefits.

(1)
(2)
(3)
(4)
(5)
(6)
Tax Shield
Present
Benefits
After Tax
Total
Value
from
Cost
Annual Factor Present
Year Depreciation Savings Benefits
12%
Value
1
$ 6,468
$37,050 $43,518 .893
$ 38,862
2
14,385
31,850
46,235 .797
36,849
3
7,665
30,550
38,215 .712
27,209
4
4,819
29,250
34,069 .636
21,668
5
6,038
27,300
33,338 .567
18,903
6
3,045
20,150
23,195 .507
11,760
Present value of incremental benefits
$155,251
k. Present value of incremental benefits
Net cost of new equipment
Net present value
$155,251
124,450
$ 30,801
Based on the present value analysis, the equipment should be

replaced.
12-57
COMPREHENSIVE PROBLEM
Lancaster Corporation (replacement decision analysis) (LO4) The Lancaster Corporation
purchased a piece of equipment three years ago for $250,000. It has an asset depreciation range
(ADR) midpoint of eight years. The old equipment can be sold for $97,920.
A new piece of equipment can be purchased for $360,000. It also has an ADR of eight years.
Assume the old and new equipment would provide the following operating gains (or losses)
over the next six years.
Year
1..............
2..............
3..............
4..............
5..............
6..............
New Equipment
$100,000
86,000
80,000
72,000
62,000
43,000
Old Equipment
$36,000
26,000
19,000
18,000
16,000
(9,000)
The firm has a 36 percent tax rate and a 9 percent cost of capital. Should the new equipment
be purchased to replace the old equipment?
CP 12-1. Solution:
Replacement Decision Analysis
Lancaster Corporation
Book Value of Old Equipment
(ADR of 8 years indicates the use of the 5-year MACRS
schedule)
Year
1
2
3
Percentage
Annual
Base
(Table 12-9) Depreciation
$250,000
.200
$ 50,000
250,000
.320
80,000
250,000
.192
48,000
$178,000
Purchase price
Book value
$250,000
178,000
$ 72,000
12-58
CP 12-1. (Continued)
Tax Obligation on the Sale
Sales price
Book value
Taxable gain
Tax rate
Taxes
$97,920
72,000
25,920
36%
$ 9,331
Cash Inflow From the Sale of the Old Equipment

Sales price
Taxes
$97,920
9,331
$88,589
Net Cost of the New Equipment

Purchase price
Cash inflow from the sale of
the old equipment
$360,000
88,589
$271,411
Depreciation Schedule of the New Equipment.

(ADR of 8 years indicates the use of 5-year MACRS Schedule)
Year
1
2
3
4
5
6
Depreciation
Base
$360,000
360,000
360,000
360,000
360,000
360,000
Percentage
Depreciation
Annual
.200
$ 72,000
.320
115,200
.192
69,120
.115
41,400
.115
41,400
.058
20,880
$360,000
12-59
Depreciation Schedule for the Remaining Years of the Old Equipment.
Year*
1
2
3
Percentage
Depreciation
Annual
.115
$28,750
.115
28,750
.058
14,500
Depreciation
Base
$250,000
250,000
250,000
*The next three years represent the last three years of the old
equipment.
Incremental Depreciation and Tax Shield Benefits.
(1)
Year
1
2
3
4
5
6
(2)
(3)
(4)
(5)
on new
on old
Incremental Tax
Equipment Equipment Depreciation Rate
$ 72,000
$28,750
$43,250
.36
115,200
28,750
86,450
.36
69,120
14,500
54,620
.36
41,400
41,400
.36
41,400
41,400
.36
20,880
20,880
.36
(6)
Tax
Shield
Benefits
$15,570
31,122
19,663
14,904
14,904
7,517
Aftertax cost savings

New
Old
Equipment Equipment
$100,000
$36,000
86,000
26,000
80,000
19,000
Cost
Savings
$64,000
60,000
61,000
12-60
(1 Tax
Rate)
.64
.64
.64
Aftertax
Savings
$40,960
38,400
39,040
72,000
62,000
43,000
18,000
16,000
(9,000)
54,000
46,000
52,000
.64
.64
.64
34,560
29,440
33,280
Present value of the total incremental benefits.
(1)
(2)
(3)
(4)
(5)
Tax Shield
Present
Benefits
After Tax
Total
Value
from
Cost
Annual
Factor
Year Depreciation Savings Benefits
9%
1
$15,570
$40,960
$56,530
.917
2
31,122
38,400
69,522
.842
3
19,663
39,040
58,703
.772
4
14,904
34,560
49,464
.708
5
14,904
29,440
44,344
.650
6
7,517
33,280
40,797
.596
Present value of incremental Benefits
(6)
Present
Value
$ 51,838
58,538
45,319
35,021
28,824
24,315
$243,855
Net Present Value

Present value of incremental benefits $243,855
271,411
Net present value
($ 27,556)
Based on the net present value analysis, the equipment should not
be replaced.
12-61

Capital Budgeting Decisions

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Chapter 12: The Capital Budgeting Decision

What are the important administrative considerations in the capital budgeting

What are the weaknesses of the payback method?

What does the term mutually exclusive investments mean?

Chapter 12: The Capital Budgeting Decision

Chapter 12: The Capital Budgeting Decision

Earnings before depreciation and taxes

Cash flow (LO2)

b. Cash flow (problem 1)

Chapter 12: The Capital Budgeting Decision

Difference in cash flow

b. Earnings before depreciation and taxes

c. $500,000- $300,000 = $200,000 or (.40 x $500,000).

Chapter 12: The Capital Budgeting Decision

a. Earnings before depreciation and taxes

b. Earnings before depreciation + taxes

Chapter 12: The Capital Budgeting Decision

Which alternatives would you select under the payback method?

Payback for Product Y

Payback Product X = 3.00 years

Chapter 12: The Capital Budgeting Decision

Which alternative would you select under the payback method?

Payback for Investment B

Payback Investment A = 4.00 years

Chapter 12: The Capital Budgeting Decision

Payback method (LO3) The Short-Line Railroad is considering a $100,000 investment in

Using the payback method, what will the decision be?

Payback for Water Works

1 year $100,000 $15,000

Payback (Electric Co.) = 3 years

Chapter 12: The Capital Budgeting Decision

Payback for Project B

Under the Payback Method, you should select Project A

Present Value of Inflows

Chapter 12: The Capital Budgeting Decision

Present Value of Inflows

Under the net present value method, you should select

Chapter 12: The Capital Budgeting Decision

Determine the internal rate of return using interpolation.

Chapter 12: The Capital Budgeting Decision

Home Security Systems

PVIF at 14% Present Value

Step 5 Since the NPV is slightly over $40,000, we need to

Chapter 12: The Capital Budgeting Decision

PVIF at 15% Present Value

Because the NPV is now below $40,000, we know the IRR

14% + ($157/$595) (1%) = .264

PVIF at 16% Present Value

Chapter 12: The Capital Budgeting Decision

14% + ($157/$1,210) (2%) = .13 (2%)

Chapter 12: The Capital Budgeting Decision

PVIF at 11% Present Value

Present value of inflows

The net present value is positive and the project should be

Chapter 12: The Capital Budgeting Decision

Cash Flow PVIF at 10% Present Value

Present Value of outflows

Present Value of inflows

= $40,000, n = 10, i = 12%

= $40,000 5.650 = $226,000

Discount from Beginning of the third period (end of second

Chapter 12: The Capital Budgeting Decision