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CAPITAL INVESTMENT
QUESTIONS FOR WRITING AND DISCUSSION
1. Independent projects are such that the
acceptance of one does not preclude the
acceptance of another. With mutually
exclusive projects, however, acceptance of
one precludes the acceptance of others.
10.
11.
12.
13.
14.
15.
9.
196
EXERCISES
201
1.
2.
3.
Payback period:
Year 1....................
Year 2....................
Year 3....................
Year 4....................
Year 5....................
Cash Flow
$ 87,500
122,500
175,000
175,000
175,000*
Unrecovered Investment
$612,500
490,000
315,000
140,000
202
1.
F = $5,000(1.03)2 = $5,304.50
2.
3.
196
203
1.
NPV = P I
= (5.335 $1,000,000) $6,000,000
= ($665,000)
The system should not be purchased.
2.
204
1.
2.
3.
4.
Year
Cash Flow
Discount Factor
0.................. $(2,340,000)
1.000
15................
702,000
3.791
NPV..............................................................................................
Present Value
$(2,340,000)
2,661,282
$ 321,282
197
205
X-ray equipment:
Year
Cash Flow
Discount Factor
0................ $(750,000)
1.000
1................
375,000
0.893
2................
150,000
0.797
3................
300,000
0.712
4................
150,000
0.636
5................
75,000
0.567
NPV.............................................................................................
Present Value
$(750,000)
334,875
119,550
213,600
95,400
42,525
$ 55,950
Biopsy equipment:
Year
Cash Flow
Discount Factor
0................ $(750,000)
1.000
1................
75,000
0.893
2................
75,000
0.797
3................
525,000
0.712
4................
600,000
0.636
5................
675,000
0.567
NPV.............................................................................................
Present Value
$(750,000)
66,975
59,775
373,800
381,600
382,725
$ 514,875
206
1.
X-ray equipment:
Payback period = $375,000
150,000
225,000
$ 750,000
1.00 year
1.00
0.75 ($225,000/$300,000)
2.75 years
Biopsy equipment:
Payback period = $ 75,000
75,000
525,000
75,000
$ 750,000
1.00 year
1.00
1.00
0.13 ($75,000/$600,000)
3.13 years
198
206
2.
Concluded
X-ray equipment:
Average cash flow = ($375,000 + $150,000 + $300,000 + $150,000 + $75,000)/5
= $210,000
Average depreciation = $750,000/5
= $150,000
Average income = $210,000 $150,000
= $60,000
Average investment = $750,000/2
= $375,000
Accounting rate of return = $60,000/$375,000
= 16%
Biopsy equipment:
Average cash flow = ($75,000 + $75,000 + $525,000 + $600,000 + $675,000)/5
= $390,000
Average investment = $750,000/2
= $375,000
Accounting rate of return = ($390,000 $150,000*)/$375,000
= 64%
*Average depreciation.
207
1.
2.
Year
Cash Flow
Discount Factor
Present Value
0............... $(370,000)
1.000
$(370,000)
1...............
450,000
0.893
401,850
NPV..............................................................................................
$ 31,850
Net present value gives the present value of future profits. (The slight
difference is due to rounding in the discount factor.)
199
208
1.
P =I
= df CF
2.914* CF = $120,000
CF = $41,181
*From Exhibit 20B-2, 14% for four years.
2.
3.
For IRR:
I = df CF
$60,096 = df $12,000
df = $60,096/$12,000
= 5.008
From Exhibit 20B-2, 18% column, the year corresponding to df = 5.008 is 14.
Thus, the lathe must last for 14 years.
200
208
4.
Concluded
= $6,075
= $6,075
= $46,610
= $20,117
209
1.
2.
NPV = P I
= (5.650 $1,500,000) $9,000,000
= ($525,000)
df = $9,000,000/$1,500,000 = 6.00
IRR is between 10% and 12% (IRR = 10.6%).
NPV and IRR also signal rejection of the project.
201
Present Value
$
(3X)
13,635
16,520
22,530
0.683X
$ 6,075
209
3.
Concluded
Present Value
$ (9,000,000)
10,170,000
322,000
$ 1,492,000
2010
1.
NPV System I:
Year
Cash Flow
Discount Factor
0.................... $(120,000)
1.000
1....................
2....................
162,708
0.826
NPV.................................................................................................
Present Value
$(120,000)
134,397
$ 14,397
202
Present Value
$(120,000)
133,026
$ 13,026
2010 Concluded
IRR System I:
I = df CF
$120,000 = $162,708/(1 + i)2
(1 + i)2 = $162,708/$120,000
= 1.3559
1 + i = 1.1645
IRR = 16.5%
IRR System II:
df = I/CF
= $120,000/$76,628
= 1.566
From Exhibit 20B-2, IRR = 18%
System II should be chosen using IRR.
2.
Modified comparison:
Year
System I
0.................... $(120,000)
1....................
2....................
162,708
*($76,628 1.10) + $76,628
System II
$(120,000)
160,919*
Notice that the future value of System I is greater than that of System II and
thus maximizes the value of the firm. NPV signals the correct choice, whereas
IRR would have chosen System II.
2011
Project I:
CF = NI + Noncash expenses
= $18,000 + $15,000
= $33,000
Project II:
CF = (1 t) (Cash expenses) + (t Noncash expenses)
= 0.6 ($30,000) + (0.4 $30,000)
= $18,000 + $12,000
= ($6,000)
2012
203
1.
Year
Depreciation
1...........
$3,000
2...........
6,000
3...........
6,000
4...........
3,000
tNC
$1,200
2,400
2,400
1,200
df
0.893
0.797
0.712
0.636
Present Value
$1,072
1,913
1,709
763
$ 5,457
2.
Year
Depreciation
1...........
$6,000
2...........
8,000
3...........
2,666
4...........
1,334
tNC
$2,400
3,200
1,066
534
df
0.893
0.797
0.712
0.636
Present Value
$2,143
2,550
759
340
$ 5,792
3.
MACRS increases the present value of tax shielding by increasing the amount
of depreciation in the earlier years.
204
2013
1.
$10,000
6,000
$16,000
3.
Year
1...............
2...............
3...............
4...............
(1 t)Ca
$(1,200)
(1,200)
(1,200)
(1,200)
(1 0.40) $2,000.
(0.40)($30,000)(0.2000).
(0.40)($30,000)(0.3200).
(0.40)($30,000)(0.1920).
(0.40)($30,000)(0.1152).
tNCb
2,400
3,840
2,304
1,382
CF
$1,200
2,640
1,104
182
205
PROBLEMS
2014
1.
2.
Year 0......................................................................................$
(420,000)
Year 1:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Depreciation shield [0.40 ($420,000/7) 0.5]...............
Total................................................................................
$ (21,000)
145,800
12,000
$ 136,800
Years 27:
Operating costs..................................................................
Savings................................................................................
Depreciation shield (0.40 $60,000)................................
Total................................................................................
$ (21,000)
145,800
24,000
$ 148,800
Year 8:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Depreciation shield (0.40 $30,000)...............................
Total................................................................................
$ (21,000)
145,800
12,000
$ 136,800
Years 910:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Total................................................................................
$ (21,000)
145,800
$ 124,800
Payback period:
$136,800
148,800
134,400
$ 420,000
3.
1.00 year
1.00
0.90
($134,400/$148,800)
2.90 years
Year
Cash Flow
Discount Factor
0................... $(420,000)
1.000
1...................
136,800
0.862
27.................
148,800
3.176
8...................
136,800
0.305
9...................
124,800
0.263
10..................
124,800
0.227
NPV.........................................................................................
Present Value
$(420,000)
117,922
472,589
41,724
32,822
28,330
$ 273,387
206
2014 Concluded
4.
1.00 year
0.81
($193,200/$238,800)
1.81 years
$434,970
128,200
$563,170
The effect of the omitted factors is greater than the included factors. While
this may not be the normal state, it emphasizes the importance of including
all related factors in the analysis. As mentioned, their exclusion may cause a
company to pass up a profitable investment opportunity.
2015
1.
207
Present Value
$(1,000,000)
508,200
287,200
585,600
$ 381,000
2015
Continued
Contemporary technology:
Year
Cash Flow
df
0.................. $(4,000,000)
1.000
1..................
200,000
0.847
2..................
400,000
0.718
3..................
600,000
0.609
46................
800,000
1.323
7..................
1,000,000
0.314
810...............
2,000,000
0.682
NPV......................................................................................
2.
Present Value
$(4,000,000)
169,400
287,200
365,400
1,058,400
314,000
1,364,000
$ (441,600)
Present Value
$(1,000,000)
526,200
307,600
714,200
$ 548,000
Contemporary technology:
Year
Cash Flow
df
0.................. $(4,000,000)
1.000
1..................
200,000
0.877
2..................
400,000
0.769
3..................
600,000
0.675
46................
800,000
1.567
7..................
1,000,000
0.400
810...............
2,000,000
0.929
NPV......................................................................................
3.
Present Value
$(4,000,000)
175,400
307,600
405,000
1,253,600
400,000
1,858,000
$ 399,600
The cost of capital is the rate that should be usedit usually reflects the
opportunity cost of the funds needed to make the investment. A higher rate
will bias against the acceptance of contemporary technologywhich usually
has large initial outlays and larger returns later in the life of the project.
Notice how the use of the 14% rate moved the NPV of the contemporary
technology alternative from a negative to a positive value. Its enough of a
movement that qualitative factors could now lead to the contemporary
technology alternative being selected even though the other alternative still
has a larger NPV.
208
2015 Concluded
4.
Traditional equipment:
Year
Cash Flow
df
0.................. $(1,000,000)
1.000
1..................
600,000
0.877
2..................
400,000
0.769
310...............
100,000
3.571
NPV......................................................................................
Present Value
$(1,000,000)
526,200
307,600
357,100
$ 190,900
2016
1.
Proposal A:
Year
Cash Flow
Discount Factor
0................... $(100,000)
1.000
1...................
150,000
0.909
2...................
125,000
0.826
3...................
75,000
0.751
4...................
37,500
0.683
5...................
25,000
0.621
6...................
12,500
0.564
NPV.........................................................................................
Present Value
$(250,000)
136,350
103,250
56,325
25,613
15,525
7,050
$ 94,113
Proposal B:
Year
Cash Flow
Discount Factor
0................... $(312,500)
1.000
1...................
(37,500)
0.909
2...................
(25,000)
0.826
3...................
(12,500)
0.751
4...................
212,500
0.683
5...................
275,000
0.621
6...................
337,500
0.564
NPV.........................................................................................
2016 Concluded
209
Present Value
$(312,500)
(34,088)
(20,650)
(9,388)
145,138
170,775
190,350
$ 129,637
2.
1.00 year
0.80
1.80 years
$150,000
200,000
$ 350,000
1.00 year
1.00
1.00
1.00
0.64
4.64 years
$ (37,500)
(25,000)
(12,500)
212,500
175,000
$ 312,500
Based on the NPV analysis, both proposals could be accepted as they have
positive NPVs. Proposal B, in fact, has the higher NPV.
4.
Kent may have accepted only Proposal A because of the fact that his
performance is going to be closely monitored over the next three years.
Proposal B had negative cash flows projected for the first three years. This
would hurt his divisional profits during that time, and he may feel that this
would hurt his chances for promotion to higher management. It is also
possible that he was concerned about the effect the proposal would have on
his bonus payments.
Kent might have rejected Proposal B because of the longer payback period.
He may have felt that this increased the risk associated with the project to an
unacceptable level. It might also be possible that the firm has liquidity
problems and needs projects with quick paybacks. The latter, however, is not
likely given the fact that his division has had high performance ratings over
the past three years.
If Kents reasons for rejecting the proposal were based on his concerns about
his promotion and bonuses rather than legitimate economic reasons, then his
behavior is unethical. To consciously subvert the legitimate objectives of an
organization for the pursuit of personal goals is not right. It might also be
noted that perhaps the organization needs to reduce its emphasis on shortterm profit performance.
210
2017
1.
2.
3.
211
2018
Keep old MRI equipment:
Year
(1 t)Ra (1 t)Cb
tNCc
CF
df
1.......
$(600,000)
$320,000
$(280,000)
0.893
2.......
(600,000)
320,000
(280,000)
0.797
3.......
(600,000)
160,000
(440,000)
0.712
4.......
(600,000)
(600,000)
0.636
5....... $(60,000)
(600,000)
(540,000)
0.567
NVP...................................................................................................................
....................................................................................................... (1,474,260)
a
0.60 $100,000.
b
c
Present Value
$ (250,040)
(223,160)
(313,280)
(381,600)
(306,180)
$
(0.60) $1,000,000.
Years 1 and 2: 0.40 $800,000; Year 3: 0.40 $400,000. The class life has two
years remaining; thus, there are three years of depreciation to claim, with the
last year being only half. Let X = Annual depreciation. Then X + X + X/2 =
$2,000,000 and X = $800,000.
100,000
0.893
89,300
2....
(300,000) 640,000
340,000
0.797
270,980
3....
(300,000) 384,000
84,000
0.712
59,808
4....
(300,000) 230,400
(69,600) 0.636
(44,266)
5.... $427,200 (300,000) 230,400
288,000
645,600
0.567
366,055
NPV................................................................................................................ $(3,158,123)
a
b
c
(0.60) $500,000.
Year 0: Tax savings from loss on sale of asset: 0.40 $1,500,000 (The loss on the
sale of the old computer is $2,000,000 $500,000.)
Years 15: Tax savings from MACRS depreciation: $5,000,000 0.20 0.40;
$5,000,000 0.32 0.40; $5,000,000 0.192 0.40; $5,000,000 0.1152 0.40;
$5,000,000 0.1152 0.40.
Note: The asset is disposed of at the end of the fifth yearthe end of its class
lifeso the asset is held for its entire class life, and the full amount of
depreciation can be claimed in Year 5.
Purchase cost ($5,000,000) less proceeds from sale of old computer ($500,000);
recovery of capital from sale of machine at the end of Year 5 is simply the book
value of $288,000 (original cost less accumulated depreciation).
212
The old MRI equipment should be kept since it has a lower cost.
2019
1.
4,560
0.162
739
NPV.....................................................................................................
$ 20,088
New system (dollars in thousands):
Year (1 t)R (1 t)Ca
tNCb
Otherc Cash Flow
df
Present Value
0.....
$ 960 $(51,000) $(50,040) 1.000
$(50,040)
110. . $18,000 $(7,740)
2,160
12,420 4.192
52,065
NPV....................................................................................................... $ 2,025
a
Year 0: Tax savings on loss from sale of old machine = 0.4 $2,400,000 =
$960,000;
Years 110: Depreciation = 0.4 $54,000,000/10 = $2,160,000.
The old system should be chosen because it has the higher NPV.
2.
4,560
0.322
NPV....................................................................................................
Present Value
$
0
25,574
1,468
$27,042
tNC
Other
CF
df
Present Value
$ 960 $(51,000) $(50,040) 1.000
$(50,040)
2,160
12,420 5.650
70,173
213
NPV.....................................................................................................
$ 20,133
Notice how much more attractive the automated system becomes when the
cost of capital is used as the discount rate.
214
2019 Concluded
3.
(1,380)
0.322
(444)
NPV.....................................................................................................
$ 13,680
*Cash expenses = Fixed + Variable
= $3,400,000 (Direct fixed) + $190X
X = Units sold
After-tax cash expense = $2,040,000 + $114X (0.6 above formula)
4.
For the new system, salvage value would increase after-tax cash flows in Year
10 by $2,400,000 (0.6 $4,000,000). Using the discount factor of 0.322, the
NPV of the new system will increase from $20,133,000 to $20,905,800 (an
increase of 0.322 $2,400,000), making the new investment more attractive.
The NPV analysis for the old system remains unchanged.
5.
215
2020
1.
Item
Equipment
Discount
Freight
Installation
Salvageold (0.6 $1,500)
Working capital reduction
CF
$(945,000)
18,900
(11,000)
(22,900)
900
2,500
2010
Operating expensesa
Depreciation tax shieldb
$(627,000)
127,987
2011
Operating expenses
Depreciation tax shieldb
$(627,000)
170,688
2012
Operating expensesa
Depreciation tax shieldb
$(651,000)
56,870
2013
Operating expenses
Depreciation tax shieldb
$(687,000)
28,454
2014
Operating expensesa
Salvagenew (0.6 $12,000)
$(687,000)
7,200
$(956,600)
(499,013)
a
(456,312)
(594,130)
a
(658,546)
(679,800)
a
Unit cost:
DM......... $10 0.75
DL .........
8 1.00
VOH.......
6 0.75
Total..........................
Depreciation shield:
Year
Value
2010
$960,000
2011
960,000
2012
960,000
2013
960,000
$ 7.50
8.00
4.50
$ 20.00
Rate
0.3333
0.4445
0.1481
0.0741
Allowance
$319,968
426,720
142,176
71,136
216
Tax Rate
0.40
0.40
0.40
0.40
Shield
$127,987
170,688
56,870
28,454
2020 Continued
Year
2010
Variable costs:
Fixed costs:
2010
Variable costs:
Fixed costs:
2012
Variable costs:
Fixed costs:
2013
Variable costs:
Fixed costs:
2014
Variable costs:
Fixed costs:
NPV:
Year
CF
df
2009................. $(956,600)
1.000
2010.................
(499,013)
0.893
2011..................
(456,312)
0.797
2012.................
(594,130)
0.712
2013.................
(658,546)
0.636
2014.................
(679,800)
0.567
NPV........................................................................................
2.
Present Value
$ (956,600)
(445,619)
(363,681)
(423,021)
(418,835)
(385,447)
$(2,993,203)
Item
Salvageold
Purchase cost:
Purchase cost:
Purchase cost:
Purchase cost:
Purchase cost:
(0.6 $1,500)
$27 50,000 0.6
$27 50,000 0.6
$27 52,000 0.6
$27 55,000 0.6
$27 55,000 0.6
=
=
=
=
=
=
CF
$
900
(810,000)
(810,000)
(842,400)
(891,000)
(891,000)
NPV:
Year
CF
df
Present Value
2009............
$
900
1.000
$
900
2010............
(810,000)
0.893
(723,330)
2011............
(810,000)
0.797
(645,570)
2012............
(842,400)
0.712
(599,789)
2013............
(891,000)
0.636
(566,676)
2014............
(891,000)
0.567
(505,197)
NPV...................................................................... $(3,039,662)
217
2020 Concluded
3.
The analysis favors internal production because it has a lower cost than
purchasing. Qualitative factors: reliability of supplier, quality of the product,
stability of purchasing price, labor relations, community relations, etc.
2021
1.
0.6 $10,000,000.
b
c
Present Value
$(50,000)
(4,000)
(1,652)
(3,425)
(4,164)
(3,786)
(3,411)
$(70,438)
0.6 $24,000,000.
218
2021 Concluded
Process redesign (expressed in thousands):
Year
(1 t)Ra
(1 t)Cb
tNCc
CF
df
0.....
$(100,000)
1.000
1..... $18,000
$(6,000) $ 8,000
20,000
0.909
2..... 18,000
(6,000) 12,800
24,800
0.826
3..... 18,000
(6,000)
7,680
19,680
0.751
4..... 18,000
(6,000)
4,608
16,608
0.683
5..... 18,000
(6,000)
4,608
16,608
0.621
6..... 19,800d
(6,000)
2,304
16,104
0.564
NPV....................................................................................................
a
0.6 $30,000,000.
b
c
Present Value
$(100,000)
18,180
20,485
14,780
11,344
10,314
9,083
$ (15,814)
0.6 $10,000,000.
The modification will add to the cost of the scrubbers and treatment facility
(present value is 0.751 $8,000,000 = $6.008 million). Cleaning up the lake
can be viewed as a cost of the first alternative or a benefit of the second. The
present value of the cleanup cost gives an additional cost (benefit) between
$30.04 and $45.06 million to the first (second) alternative (0.751
$40,000,000) and (0.751 $60,000,000). Adding in the benefit of avoiding the
cleanup cost makes the process redesign alternative profitable (yielding a
positive NPV). Ecoefficiency basically argues that productive efficiency
increases as environmental performance increases and that it is cheaper to
prevent environmental contamination than it is to clean it up once created.
The first alternative is a cleanup approach, while the second is a
prevention approach.
219
2022
1.
(1 t)Cb
$(180,000)
tNCc
$8,000
Cash Flows
$68,000
b
c
(1 t)Ra
$240,000
0.40 $20,000.
Robotic system:
Year
(1 t)Ra
0.....
1..... $240,000
2..... 270,000
3..... 300,000
4..... 360,000
5..... 360,000
6..... 360,000
7..... 360,000
8..... 360,000
9..... 360,000
10.... 372,000
a
(1 t)Cb
$(124,320)
(132,960)
(141,600)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)
tNCc
$64,000
29,723
50,939
36,379
25,979
18,574
18,554
18,574
9,277
Otherd
$(480,000)
Cash Flows
$(416,000)
145,403
187,979
194,779
227,099
219,694
219,674
219,694
210,397
201,120
213,120
220
2022 Continued
Variable:
Direct materials........ (0.16 Sales) 0.75 0.60
Variable overhead.... (0.09 Sales) 0.6667 0.60
Variable selling........ (0.12 Sales) 0.90 0.60
Total......................................................................
=
=
=
=
0.0720 Sales
0.0360 Sales
0.0648 Sales
0.1728 Sales
2.
Net investment:
Purchase costs............. $520,000
Recovery of capital...... (40,000)
Tax savings on loss..... (64,000)
$ 416,000
Manual system:
Year
Cash Flow
Discount Factor
Present Value
0......................
$
0
1.000
$
0
110..................
68,000
5.650
384,200
NPV.............................................................................................
$ 384,200
Robotic system:
Year
Cash Flow
Discount Factor
Present Value
0...................... $(416,000)
1.000
$ (416,000)
1......................
145,403
0.893
129,845
2......................
187,979
0.797
149,819
3......................
194,779
0.712
138,683
4......................
227,099
0.636
144,435
5......................
219,694
0.567
124,566
6......................
219,674
0.507
111,375
7......................
219,694
0.452
99,302
8......................
210,397
0.404
85,000
9......................
201,120
0.361
72,604
10.....................
213,120
0.322
68,625
NPV.............................................................................................
$ 708,254
The company should invest in the robotic system.
221
2022 Concluded
3.
Managers may use a higher discount rate as a way to deal with the
uncertainty in future cash flows. The higher rate protects the manager from
unpleasant surprises. Since a higher rate favors investments that provide
returns quickly, managers may be motivated by personal short-run
considerations, e.g., bonuses and promotion opportunities.
Using a discount rate of 12%:
Year
Cash Flow
Discount Factor
Present Value
0.................... $(340,000)
1.000
$(340,000)
110.................
80,000
5.650
452,000
NPV.............................................................................................
$ 112,000
Using a discount rate of 20%:
Year
Cash Flow
Discount Factor
Present Value
0.................... $(340,000)
1.000
$(340,000)
110.................
80,000
4.192
335,360
NPV.............................................................................................
$ (4,640)
If the 20% discount rate is used, the company would not acquire the robotic
system.
Using an excessive discount rate could seriously impair the ability of the firm
to stay competitive. An excessive discount rate may lead a firm to reject new
technology that would increase quality and productivity. As other firms invest
in the new technology, their products will be priced lower and be of higher
quality, features which would likely cause severe difficulty for the more
conservative firm.
222
2.
Laura should not comply with Peters request; she should attempt to
convince Peter that a different approach is better. For example, she might
advise him to talk with those who prepared the report. Perhaps he could
convince them that they overlooked some significant factors in favor of the
project. At the very least, this approach would enable Peter to again review
the findings, with the hope that either he or the consultants will alter their
views.
3.
If Laura complies with Peters request, some of the standards that would be
violated are as follows:
4.
I-3.
III-7.
IV-1.
IV-2.
223