Solution manual cost management measuaring monitoring and motivating performance 1st by wolcott ch12

Q2 What cash flows are relevant for strategic investment decisions?. Q5 What alternative methods IRR, payback, and accrual accounting rate of return are used for strategic investment dec

Chapter 12 Strategic Investment Decisions

LEARNING OBJECTIVES

Chapter 12 addresses the following questions:

Q1 How are strategic investment decisions made?

Q2 What cash flows are relevant for strategic investment decisions?

Q3 How is net present value (NPV) analysis performed and interpreted?

Q4 What are the uncertainties and limitations of NPV analysis?

Q5 What alternative methods (IRR, payback, and accrual accounting rate of return) are used for strategic investment decisions?

Q6 What additional issues should be considered for strategic investment decisions?

Q7 How do income taxes affect strategic investment decision cash flows?

Q8 How are the real and nominal methods used to address inflation in an NPV analysis? (Appendix 12A)

These learning questions (Q1 through Q8) are cross-referenced in the textbook to individual exercises and problems

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems

Questions Having a Single Correct Answer:

textbook

e This question requires students to extend knowledge beyond the applications

shown in the textbook

Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):

 Step 1 skills (Identifying)

 Step 2 skills (Exploring)

 Step 3 skills (Prioritizing)

 Step 4 skills (Envisioning)

QUESTIONS

small, and the incremental affect of future cash flows is therefore small According to the present value tables, after about 15 years, the incremental values at rates above 8 to 10% are small (less than 20% of the original value) If these cash flows are small, but include error, the size of error would also be small and likely have little effect on the overall analysis

for that group or portfolio of projects, whereas IRR can be neither summed nor averaged

In addition, NPV provides information about the value of the projects in terms of today’s dollars If projects are of different sizes, requiring large and small investments, NPV reflects these differences IRR provides only a rate of return, and comparing rates of return does not take into consideration the size of return In addition, the net present value method is computationally simpler than the internal rate of return method

Determining IRR can be time consuming, particularly for projects having uneven cash flows However, the use of a spreadsheet reduces the effort considerably

An important difference between the two methods is that the IRR method assumes cash inflows can be reinvested to earn the same return that the project would generate

However, it may be difficult for an organization to identify other opportunities that could achieve the same rate when IRR is high In contrast, the NPV method assumes that cash inflows can be reinvested and earn the discount rate—a more realistic assumption If the discount rate is set equal to the organization’s cost of capital, then alternative uses of cash would include paying off creditors or buying back stock Therefore, if the results of analyses using the two methods are not the same, the NPV method is preferable

Both methods are used widely in business One reason for the continued use of IRR is that many people find it intuitively easier to understand than NPV In addition, managers may want to compare the IRR on prior projects to current project return rates as they consider new investment

It is sometimes more difficult to estimate cash flows and choose an appropriate discount rate for NPV than finding the internal rate of return or calculating payback or an accounting rate of return

(b) Internal Rate of Return (IRR)

Pros:

Many managers find IRR intuitively easier to understand than NPV IRR has the same advantage as NPV of including the time value of money IRR can be used to compare potential projects (choose the one with highest IRR)

Cons:

Assumes cash flows can be reinvested at the IRR When comparing projects, IRR does not take into consideration size of investment and may be inappropriate when managers need to choose among competing projects because capital is constrained

IRRs from several projects cannot be summed or averaged, while net present values can

IRR is computationally more difficult than NPV and the other methods, particularly with uneven cash flows

(c) Payback Method

Pros:

Used extensively, particularly outside of the U.S

Focuses on high risk of long payback period Cons:

Does not incorporate time value of money Ignores cash flows received after the investment is recovered (d) Accrual Accounting Rate of Return

the uncertainties increase Changes in economic, political, and consumer tastes that affect cash flows cannot be easily predicted More information is usually available about near-term economic factors than long-term

small across time to reflect the fact that investors forego interest on cash flows that are received in the future relative to cash flows that are received today and could be invested today This discounting reflects the opportunity cost (interest foregone) when money is received in the future instead of today

12.6 A nominal discount rate includes a factor for inflation, and the real rate does not Both

rates include a risk-free rate and a risk premium Using a nominal approach, different cash flows can be inflated differentially For example, gasoline prices might inflate at a different rate than wages If different types of cash flows are differentially inflated to better reflect future expectations, the preciseness of the estimation and analysis process increases and information quality increases

to remain fixed If a firm has cash in a bank earning interest, the after-tax return could be less than the inflation rate Therefore the firm’s cash would be losing purchasing power over time In this case it would be better for the firm to invest in a real asset that

increases at the inflation rate or greater

assuming that the cost of capital is constant across investments

of coping with increased problems of uncertainty and risk Less developed countries usually have less stable political systems, economies, inflation rates, and consumer markets In addition, infrastructure such as roads and utilities is sometimes unreliable, so production and transportation problems could occur more frequently These factors increase the risk of doing business in developing countries

From the host government's point of view, if a higher rate of return is not permitted under such circumstances, the investment would probably never have been made at all, and the developing country would be worse off as a result The firm, however, must be careful to avoid any perception of exploitation, as the long-term reputation effect could be

devastating

12.10 There are two reasons to incorporate tax effects more formally into NPV analyses From

an accounting standpoint, tax regulations permit a shift of both the amount and the timing (sometimes permanently) of taxes; this will have an effect on present values If tax savings based on current tax rules are not incorporated into the analysis, these effects are not captured and the analysis is less accurate From a mathematical standpoint, the factors in the tables are not linearly related (all of the formulas have exponents); e.g., the present value factor for 20% is not one-half of the factor for 10%

12.11 The return on the investment portfolio represents the clinic's opportunity cost for funds

They can earn at least that return; therefore, any other investment must yield a higher return

EXERCISES

12.12 Time Value of Money

A Using tables, the answer is ($8,000 x 0.583) = $4,664

Using Excel, the answer is $4,667.92

B Using the tables, the answer is ($125 x 1.791) = $223.88

Using Excel, the answer is $223.86

C Using tables, the answer is ($10,000 x 0.747) = $7,470

Using Excel, the answer is $7,472.58

D Using tables, the answer is ($1,000 x 0.507) = $507

Using Excel, the answer is $506.63

12.13 Capital Budgeting Process

The proper sequence is: 4, 1, 5, 2, 3, and 6

12.14 Overnight Laundry

Cash Flow Timeline:

(a) The salvage value is ignored for income tax depreciation, so the annual

depreciation = $96,000/10 years = $9,600 per year Taxes per year = ($25,000 - $9,600) * 33.3% = $5,128 NPV calculation:

NPV = $(96,000) + $19,872 (PVFA 18%, 10 years) + $6,000 (PVF 18%, 10 years)

= $(96,000) + ($19,872 x 4.494) + ($6,000 x0.191)

= $(96,000) + $89,305 + $1,146

= ($5,549)

12.15 Axel Corporaton

The net present value is $30,000 (5.019) - 150,000 = $570

The internal rate of return is a little higher than 15% Using Excel, the actual rate is

15.098%

12.16 Amaro Hospital

A The net present value is ($5,000 x 5.216) - 20,000 = $6,080

B The factor for the internal rate of return must be

20,000 = $5,000*Factor Factor = 4.0

From the PVFA tables for 10 year, it would be just over 20% (PVFA = 4.192)

Using Excel’s IRR function, the rate is 21.4%

C Assuming straight-line depreciation, the earnings will be

$5,000 - $20,000/10 = $3,000

The accounting rate of return is $3,000/20,000 = 15%

D The payback period is $20,000/$5,000 = 4

12.17 Crown Corporation

A The PVFA for four payments discounted at 6% is 3.465 Thus, the present value of the

note is $1,000 x 3.465 = $3,465 With the down payment, the total is $4,465

B Because this is a single payment the factor is a present value single amount of 0.735, so the total is $4,000 x 735 = $2,940 With the down payment it becomes a total present

value selling price of $3,940

C The selling price of the equipment is $5,000 no matter how the employee gets the cash and what Crown does with the $5,000 The future value factor for three years hence is

1.225, yielding: $5,000 x 1.225 = $6,125

12.18 Clearwater Bottling Company

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg)

A

Cash Flow Timeline:

Incremental cash flows:

= ($20,000 - $20,000) * 25% = $0

B The NPV for this part can easily be calculated manually as shown below The sample spreadsheet shows the NPV to be $(27,904) The difference is due to rounding

NPV = $(100,000) + $20,000 (PVFA 12%, 5 years) NPV = $(100,000) + $20,000 x 3.605

NPV = $(27,900)

C To determine the amount of sales needed to bring the NPV to zero, first re-write the incremental cash flows substituting Q for the volume of cases sold

Cash Flow Timeline:

Incremental cash flows:

Next, set the NPV equal to zero and solve for Q:

0 = $(100,000) + ($1.5Q - $5,000) x 3.605

= = $(100,000) + 5.4075Q - $18,025 5.4075Q = $118,025

Q = 21,826 cases

D Below is an excerpt from the sample spreadsheet showing calculations using the nominal method:

Incremental operating cash flow:

Incremental fixed costs per year $20,000

Incremental Operating Cash Flows:

Incremental variable costs (140,000) (140,000) (140,000) (140,000) (140,000)

Net incremental operating cash flows $15,000 $15,000 $15,000 $15,000 $15,000 Nominal incremental operating cash flows $15,600 $16,224 $16,873 $17,548 $18,250

Calculation of depreciation tax shield

Depreciation Deduction (nominal) $33,330 $44,450 $14,810 $7,410

Present value of annual cash flows

Sum of PV of annual cash flows $72,765

Less initial investment ($100,000)

Below is an excerpt from the sample spreadsheet showing calculations using the real method:

Incremental operating cash flow:

Incremental fixed costs per year $20,000

Incremental Operating Cash Flows:

Incremental variable costs (140,000) (140,000) (140,000) (140,000) (140,000)

Net incremental operating cash flows $15,000 $15,000 $15,000 $15,000 $15,000

Calculation of depreciation tax shield

Depreciation Deduction (nominal) $33,330 $44,450 $14,810 $7,410

Depreciation deduction (real) $32,048 $41,097 $13,166 $6,334

Present value of annual cash flows

Sum of PV of annual cash flows $72,765

Less initial investment ($100,000)

12.19 Parish County

This problem is most easily solved in steps First determine the present value of the terminal cash flow:

Terminal value = $400,000 x 20% = $80,000 Present value = $80,000 x (PVF, 10%, 5 years) = $80,000 x 0.621 = $49,680

Subtract the present value of the terminal value from the investment to determine the present value needed from annual savings to justify the purchase:

Minimum PV of annual savings = $400,000 - $49,680 = $350,320

Finally, determine the annual savings needed to achieve the present value calculated

above The following calculation assumes that the annual savings would be identical

during each of the 5 years

Savings x (PVFA, 10%, 5 years) = $350,320 Savings x 3.791 = $350,320

NPV calculation:

NPV = -$60,000 + $22,000 x (PVFA 10% 6 years) NPV = -$60,000 + $22,000 x 4.355 = $35,810

C To determine the payback period, first summarize the cumulative cash flows from the

The original investment is $60,000, which is expected to be paid back between 2 and 3

years If the cash flows are assumed to occur evenly throughout each year, the payback

period is 2.73 years [(2 + (60,000 - 44,000)/22,000)] Because cash flows are identical

across years, the payback can also be calculated as follows: $60,000/$22,000 = 2.73

years

Based solely on the internal rate of return, the projects would be ranked 4, 2, 3, and 1

B There appear to be considerable differences in risk among the projects Projects 2 and 3 expect negative incremental operating cash flows during some of the years, and project 4 expects zero incremental operating cash flows during 2 of the 6 years Projects 2, 3, and

4 show more variation across years than project 1 If there is a high rate of technological change in this industry, management may prefer project 2, which pays back most of the investment quickly

12.22 Lymbo Company, Inc

A Based on the NPV of the two alternatives, the company should choose Alternative 2 with

a less negative NPV than Alternative 1 Calculations for each alternative are shown below

Cash Flow Timeline for Alternative 1:

(a) Depreciation = $100,000/5 years = $20,000 per year Incremental taxes deductions during years 1-5 = (Maintenance cost + Depreciation) * 30%

= ($20,000 + $20,000) * 30% = $12,000 (b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%

= $20,000 * 30% = $6,000

NPV Calculation for Alternative 1:

NPV = $(100,000) + [$(8,000) x (PVFA 12%, 5 years)] + [$(14,000) x (PVFA 12% 15 years – PVFA 12% 5 years)]

NPV = $(100,000) + [$(8,000) x 3.605] + [$(14,000) x (6.811 – 3.605]

NPV = $(100,000) + $(28,840) + $(44,884) = $(173,724) Following is a different way to perform the same calculations for Alternative 1:

Cash Flow Timeline for Alternative 2:

(a) Depreciation = $150,000/5 years = $30,000 per year Incremental taxes deductions during years 1-5 = (Maintenance cost + Depreciation) * 30%

= ($10,000 + $30,000) * 30% = $12,000 (b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%

= $10,000 * 30% = $3,000 NPV Calculation for Alternative 2:

NPV = $(150,000) +[ $2,000 x (PVFA 12%, 5 years)] + [$(7,000) x (PVFA 12%

15 years – PVFA 12% 5 years)]

NPV = $(150,000) + [$2,000 x 3.605] + [$(7,000) x (6.811 – 3.605)]

NPV = $(150,000) + $7,210 + $(22,442) = $(165,232) Following is a different way to perform the same calculations for Alternative 2:

B Following are the NPV calculations without the depreciation tax shield:

NPV without income taxes for Alternative 1:

B First calculate the present value factor for an annuity of 5 payments that equates the cash inflows and outflows:

$300,000 * F = 940,000

F = 3.13333

A factor of 3.13333 represents an internal rate of return of slightly less than 18%

A spreadsheet could be used to determine the exact answer of 17.913%

C Assuming the cash flows take place evenly throughout the year:

$940,000/$300,000 = 3.13 years

PROBLEMS

12.24 Jackson

[Note about problem complexity: Item B is not coded as Step 3 because this is explicitly

discussed in the chapter.]

A The choices are (1) hold the stock and work for $90,000 per year or (2) sell the stock, do

not take the job, and start the restaurant This is a long-term decision

B Either IRR or NPV methods could be used for this analysis The decision is a long-term decision and therefore needs to include the time value of money Both of these methods

do that With the NPV method, inflation rates for different categories of costs could be used, so the results would be more precise In addition, it may be easier to understand the differences in these two plans in today’s dollars, rather than in rates of returns

C His opportunity costs are $90,000 plus benefits from the job offer, plus the return on the stock

D The following categories would be set into an input box: Investment amount, risk free rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates, all of the cash flows from the restaurant (revenues and variable and fixed costs) Once these are in the input box, formulas for calculating the incremental cash flows over time need to be set up, and the real cash flows would need to be inflated and then discounted

If depreciation is relevant for the investment, a MACRS table would need to be added

E Uncertainties about a new job include lack of information about the people Jackson would work with, and also about the nature of the work to be done The future of the company is not guaranteed Students may have thought of other uncertainties

F Jackson faces uncertainties about customer preferences, which will result in uncertainty about revenues He has not operated a restaurant, so he faces uncertainties about current costs and cost trends over time He also faces uncertainties about the quality and quantity

of employees available to cook, wait tables, and perform other tasks that need to be done

G Jackson faces many uncertainties, no matter which alternative he chooses If he performs sensitivity analyses around each alternative and formally incorporates qualitative factors, such as the amount of enjoyment he takes in his current position and his perceptions of this aspect of owning a restaurant, he will be able to make a high quality decision

12.25 Homeless Shelter

[Notes about problem complexity: Part A is not coded as Step 2 because the advantages and

disadvantages are explicitly presented in the text Part C will be quite difficult for most

Without spreadsheets, it is time consuming to calculate

It does not take into consideration the relative size of projects

It does not give information about the dollar value of the investment

B The discount rate should be different for every project because the risk of every project is different Part of the discount rate is the risk premium, and that should be higher for projects that are riskier

C For discount rates, the following information would be helpful: current and historical inflation rates and T-bill rates In addition, historical financial information about the three alternative projects or similar projects in similar would be important to develop the risk premium Information about demand for rooms, apartments, and boxes would be needed Information about the availability of management and employees for the three alternatives would be useful

D The answer to this question depends in part upon the assumptions made about the current operations of the homeless shelter If the shelter’s current operations are similar to an apartment complex, the second alternative is probably least risky because of the rent subsidization, the first alternative next most risky, and the manufacturing operation most risky Information about demand and employee stability is likely to be more uncertain than information about occupancy rates, etc However, if the homeless shelter is just a large space with cots for homeless people, the managers’ experience may be irrelevant when considering risk

The amount of financial risk also depends on the size of investment The managers need

to consider potential problems that could affect financial outcomes A hotel that offers rooms based on ability to pay could attract people who are using the hotel for illegal activities and require a great deal of monitoring Alternatively, the manufacturing

operation requires managers who are trained to work with homeless people and skilled at managing manufacturing operations To better understand the financial risks for the three different types of operations, the managers may want to find similar businesses in the local area and examine their revenues and expenses across time Managers of not-for-profit organizations are often willing to share information with each other

12.26 Real Interest Rates

A The real rate includes both a risk free rate and a risk premium

B The risk free rate is affected by decisions by the Federal Reserve about the prime rate, and economic growth rates The level of uncertainty and potential volatility of the cash flows for the project affect the risk premium

C Interest rates vary a great deal across time They are affected by government policy, inflation, stock market returns, and many other factors that are difficult to predict

D Yes, the length of the project can make a difference in the certainty of the chosen rate Interest and inflation rates usually trend across time; they move slowly up or down If the project has a short life (3-5 years) and rates are currently low (or high), managers would expect them to rise ( or decrease), but slowly The choice of discount rate is less certain for projects with long lives (15-20 years or more) Interest and inflation rates could vary a great deal over this length of time, and predicting the average rate for the entire time period involves more uncertainty

12.27 Green Jade Resorts

A

Net Present Value (NPV): The sum of today’s and future cash flows discounted to

today’s dollars

Internal Rate of Return (IRR): Discount rate necessary for the present value of the

discounted cash flows to be equal to the investment

Payback Method: Measures the amount of time required to recover the initial investment Accrual Accounting Rate of Return: Expected increase in average annual operating

income as a percent of the initial increase in required investment