Solution manual managerial accounting 8e by hansen mowen ch 13

The timing and quantity of cash flows de-termine the present value of a project.. Essentially, net present value is a measure of the return in excess of the in-vestment and its cost o

CHAPTER 13 CAPITAL INVESTMENT DECISIONS QUESTIONS FOR WRITING AND DISCUSSION

1 Independent projects are such that the

ceptance of one does not preclude the

ac-ceptance of another With mutually exclusive

projects, acceptance of one precludes the

acceptance of others

2 The timing and quantity of cash flows

de-termine the present value of a project The

present value is critical for assessing

wheth-er a project is acceptable or not

3 By ignoring the time value of money, good

projects can be rejected and bad projects

accepted

4 The payback period is the time required to

recover the initial investment Payback =

$80,000/$30,000 = 2.67 years

5 (a) A measure of risk Roughly, projects with

shorter paybacks are less risky (b)

Obso-lescence If the risk of obsolescence is high,

firms will want to recover funds quickly (c)

Self-interest Managers want quick

pay-backs so that short-run performance

meas-ures are affected positively, enhancing

chances for bonuses and promotion Also,

this method is easy to calculate

6 The accounting rate of return is the average

income divided by original or average

in-vestment ARR = $100,000/$300,000 =

33.33%

7 Agree Essentially, net present value is a

measure of the return in excess of the

in-vestment and its cost of capital

8 NPV measures the increase in firm value

from a project

9 The cost of capital is the cost of investment

funds and is usually viewed as the weighted

average of the costs of funds from all

sources It should serve as the discount rate

for calculating net present value or the

benchmark for IRR analysis

11 If NPV > 0, then the investment is

accepta-ble If NPV < 0, then the investment should

be rejected

12 Disagree Only if the funds received each

period from the investment are reinvested to earn the IRR will the IRR be the actual rate

of return

13 Postaudits help managers determine if

re-sources are being used wisely Additional resources or corrective action may be needed Postaudits also serve to encourage managers to make good capital investment decisions They also provide feedback that may help improve future decisions

14 NPV signals which investment maximizes

firm value; IRR may provide misleading nals IRR may be popular because it pro- vides the correct signal most of the time and managers are accustomed to working with rates of return

sig-15 Often, investments must be made in assets

that do not directly produce revenues In this case, choosing the asset with the least cost (as measured by NPV) makes sense

16 NPV analysis is only as good as the

accura-cy of the cash flows If projections of cash flows are not accurate, then incorrect in- vestment decisions may be made

17 The quality and reliability of the cash flow

projections are directly related to the sumptions and methods used for forecast- ing If the assumptions and methods are faulty, then the forecasts will be wrong, and incorrect decisions may be made

as-18 The principal tax implications that should be

considered in Year 0 are gains and losses

on the sale of existing assets

20 The half-year convention assumes that an

asset is in service for only a half year in the

year of acquisition Thus, only half of the first

year’s depreciation can be claimed,

regard-less of the date on which use of the asset

actually began It increases the length of

time depreciation is recognized by one year

over the indicated class life

21 Intangible and indirect benefits are of much

greater importance in the advanced

manu-facturing environment Greater quality, more

reliability, improved delivery, and the ability

to maintain or increase market share are examples of intangible benefits Reduction

in support labor in such areas as scheduling and stores are indirect benefits

22 Sensitivity analysis changes the

assump-tions on which the capital investment sis is based Even with sound assumptions, there is still the element of uncertainty No one can predict the future with certainty By changing the assumptions, managers can gain insight into the effects of uncertain fu- ture events

EXERCISES 13–1

13–3

1

Initial investment (Average depreciation = 300,000):

Accounting rate of return = Average accounting income/Investment

Project A should be chosen

3 ARR = Average Net Income/Average Investment

4 ARR = Average Net Income/Investment

0.50 = Average Net Income/$200,000

Average Net Income = 0.50 × $200,000

1 P = CF(df) = I for the IRR, thus,

df = Investment/Annual cash flow

= $1,563,500/$500,000

= 3.127

For five years and a discount factor of 3.127, the IRR is 18%

2 P = CF(df) = I for the IRR, thus,

df = $521,600/$100,000 = 5.216

For ten years, and a discount factor of 5.216, IRR = 14%

Yes, the investment should be made

3 CF(df) = I for the IRR, thus,

CF = I/df = $2,400,000/4.001 =$599,850

13-6

1 Larson Blood Analysis Equipment:

13-6 Concluded

Lawton Blood Analysis Equipment:

2 a Initial investment (Average depreciation = 160,000):

Accounting rate of return = Average accounting income/Investment

= ($300,000 – $160,000)/$800,000

4 P = CF(df) = I for the IRR, thus,

df = Investment/Annual cash flow

Net present value gives the present value of future profits (the slight ence is due to rounding error in the discount factor)

It is not necessary to subtract the interest payments and the dividend ments because these are associated with the cost of capital and are included

pay-in the firm’s cost of capital of 10 percent

13–11

1 P = I = df × CF

2.914* × CF = $120,000

*From Exhibit 13B-2, 14 percent for four years

2 For IRR (discount factors from Exhibit 13B-2):

= $10,000 in savings each year

Substituting CF = $10,000 into equation (1):

From Exhibit 13B-2, 18 percent column, the year corresponding to df = 5.008

is 14 Thus, the lathe must last 14 years

From Exhibit 13B-2, IRR = 18 percent

Project II should be chosen using IRR

2 NPV is an absolute profitability measure and reveals how much the value of the firm will change for each project; IRR gives a measure of relative profita- bility Thus, since NPV reveals the total wealth change attributable to each project, it is preferred to the IRR measure

3 MACRS increases the present value of tax shielding by increasing the amount

of depreciation in the earlier years

13–16

1 Standard equipment (Rate = 18%):

CAM equipment (Rate = 18%):

2 Standard equipment (Rate = 10%):

CAM equipment (Rate = 10%):

13–16 Concluded

3 Notice how the cash flows using a 10 percent rate in Years 8–10 are weighted

compared to the 18 percent rate The difference in present value is significant

Using an excessive discount rate works against those projects that promise

large cash flows later in their lives The best course of action for a firm is to

use its cost of capital as the discount rate Otherwise, some very attractive

and essential investments could be overlooked

13–17

1 Standard equipment (Rate = 14%):

CAM equipment (Rate = 14%):

2 Standard equipment (Rate = 14%):

The decision reverses—the CAM system is now preferable This reversal is

attributable to the intangible benefit of maintaining market share To remain

competitive, managers must make good decisions, and this exercise

empha-sizes how intangible benefits can affect decisions

PROBLEMS 13–18

1 Accounting rate of return

• Merits: The ARR method is relatively simple to use and easy to understand

It considers the profitability of the projects under consideration

• Limitations: It ignores cash flows and the time value of money

Internal rate of return

• Merits: It considers the time value of money It measures the true rate of

re-turn of the project and productivity of the capital invested Furthermore, managers are accustomed to working with rates of return

• Limitations: It is stated as a percentage rather than a dollar amount It

as-sumes that cash flows are reinvested at the IRR of the project It may not select the project that maximizes firm value

Net present value method

• Merits: It considers the time value of money and the size of the investment

It measures the true economic return of the project, the productivity of the capital, and the change in wealth of the shareholders

• Limitations: It does not calculate a project’s rate of return, and it assumes

that all the cash flows are reinvested at the required rate of return

Payback method

• Merits: It provides a measure of the liquidity and risk of a project

• Limitations: It ignores the time value of money It ignores cash flows

beyond the payback period and, thus, ignores the profitability of a project

2 Nathan Skousen and Jake Murray are basing their judgment on the results of the net present value and internal rate of return calculations These are both considered better measures because they include cash flows, the time value

of money, and the project’s profitability Project B is better than Project A for both of these measures

13–18 Concluded

3 At least three qualitative considerations that should generally be considered

in capital budgeting evaluations include:

• Quicker response to market changes and flexibility in production capacity

• Strategic fit and long-term competitive improvement from the project, or

the negative impact to the company’s competitiveness or image if it does

not make the investment

• Risks inherent in the project, business, or country for the investment

13–19

1 Schedule of cash flows:

13–20

1 Schedule of cash flows:

The IRR is 16 percent The company should acquire the new system

2 Since I = P for the IRR:

I = df × CF

$96,660 = 6.145* × CF

6.145 × CF = $96,660

*Discount factor at 10 percent (cost of capital) for ten years

3 For a life of eight years:

4 Requirement 2 reveals that the estimates for cash savings can be off by

as much $4,270 (over 20 percent) without affecting the viability of the new system Requirement 3 reveals that the life of the new system can

be two years less than expected and the project is still viable In the ter case, the cash flows can also decrease by almost ten percent as well without changing the outcome Thus, the sensitivity analysis should strengthen the case for buying the new system

lat-13–22

1 The IRR using the best estimates:

Unit variable cost 4

Unit contribution margin $ 6

Total contribution margin ($6 × 1,000,000 annual sales volume) $ 6,000,000

Discount factor = $12,000,000/$4,000,000 = 3.00

Five years and a discount factor of 3.00 implies a rate of approximately 20 percent

2 a If the per-unit selling price is reduced 10 percent, the adjusted IRR is 8

percent, as calculated below:

90% of selling price $9

Unit variable cost 4

Total contribution margin ($6 × 900,000 annual sales volume) $5,400,000

Discount factor = $12,000,000/$3,400,000 = 3.53, which implies an IRR that

is approximately 13 percent (IRR between 12 and 14 percent)

c If the per-unit variable cost is reduced 10 percent, the adjusted IRR is 24 percent, as calculated below:

Unit variable cost 3.60

Contribution margin $ 6.40

Total contribution margin

($6.40 × 1,000,000 annual sales volume) $6,400,000

Discount factor = $12,000,000/$4,400,000 = 2.73, which implies an IRR that

is approximately 24 percent

3 Sensitivity analysis determines the impact that certain changes in tions have on IRR or NPV as appropriate It helps management to identify key variables and to know whether additional information is needed It also helps determine the volatility of the project Sensitivity analysis is limited because it provides no information about probability and uncertainty The range of val- ues possible with their probability of occurrence are important information It also ignores the fact that assumptions are dynamic and can interact with each other

assump-13–23

1 First, calculate the expected cash flows:

Days of operation each year: 365 – 15 = 350

Revenue per day: $200 × 2 × 150 = $60,000

Yes, the aircraft should be purchased

2 Revised cash flow = (0.80 × $21,000,000) – $2,500,000

= 126 seats (each way)

Seating rate needed = 126/150 = 84%

13–23 Concluded

4 Seats to be sold = $50,283/$440 = 115 (rounded up)

Seating rate = 115/150 = 77%

This seating rate is less than the most likely and above the least likely rate of

70 percent There is some risk, since it is possible that the actual rate could

be below 77 percent However, the interval is 20 percent (70 percent to 90 percent), and the 77 percent rate is only 35 percent of the way into the inter- val, suggesting a high probability of a positive NPV

Note: Cash flow = Increased revenue less cash expenses of $3,000

2 Accounting rate of return using original investment:

Average cash flow = ($16,800 + $24,000 + $29,400 + $29,400)/4

Accounting rate of return using average investment:

Accounting rate of return = $7,900/$40,000*

*Average investment = (Investment + Salvage)/2

*Includes $6,000 salvage value

IRR (by trial and error):

Using 14 percent as the first guess:

The IRR is about 14 percent

The equipment should be purchased (The NPV is positive and the IRR is larger than the cost of capital.) Dr Avard should not be concerned about the accounting rate of return in making this decision The payback, however, may

be of some interest, particularly if cash flow is of concern to Dr Avard

4 Year Cash Flow Discount Factor Present Value

For Years 1–4, the cash flows are 2/3 of the original cash flow increases Year

4 also includes $6,000 salvage value

Given the new information, Dr Avard should not buy the equipment

13–25

Keep old computer:

Year (1 – t)R a –(1 – t)C b tNC c CF df Present Value

c Years 1 and 2: 0.40 × $80,000; Year 3: 0.40 × $40,000 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 = $200,000 and X =

c Year 0: Tax savings from loss on sale of asset: 0.40 × $150,000 (The loss on the

sale of the old computer is $200,000 – $50,000.)

Years 1–5: Tax savings from MACRS depreciation: $500,000 × 0.20 × 0.40;

$500,000 × 0.32 × 0.40; $500,000 × 0.192 × 0.40; $500,000 × 0.1152 × 0.40;

$500,000 × 0.1152 × 0.40

Note: The asset is disposed of at the end of the fifth year—the end of its class

life—so the asset is held for its entire class life, and the full amount of

deprecia-tion can be claimed in Year 5

d Purchase cost $500,000 less proceeds of $50,000; recovery of capital from sale

of machine, end of Year 5, is the book value of $28,800 (original cost less

accu-mulated depreciation)

d Includes salvage value as a gain

Lease—with service contract:

Year (1 – t)R –(1 – t)C a tNC b Cash Flow

c Includes deposit of $5,000 and purchase of contract of $30,000

d Includes the refund of the $5,000 deposit