Solution manual cost accounting by lauderbach CAPITAL BUDGETING PART i

Investment will increase because net cash flows will increase and more projects will meet DCF criteria.. Some students might ask about the value of depreciation deductions, which will fa

CHAPTER 7

CAPITAL BUDGETING−PART I

7-1 Risk and Capital Investments

Colgate faces lower risk than J&J because it is expanding production of

an existing, and successful, product The major risk is that the product will become less popular and sales will not materialize The new plant couldalso be too costly, but that seems unlikely as the technology to make

consumer products is well-established

J&J faces risks that the drug will not prove efficacious, that the Foodand Drug Administration will not approve it, or that another company will develop a better drug One reason we use this example is to make the point that R&D is just like any other investment, except that no depreciation is involved

7-2 Payback and Risk

Either voyage is acceptable, but most students will probably select the shorter, safer one

A lot can happen to a ship on a long voyage−storms, piracy, or collisionswith icebergs or rocks Considering the hazards, who wouldn't feel a lot safer tying up his or her money for one year rather than five despite the advantage of the longer voyage as determined under the normal techniques of analysis? Whether you would choose to invest in the one-year or the five-year opportunity depends on your attitude about risk and return Because of its emphasis on the rapidity of return of investment, the payback method of evaluation gives higher priority to the one-year voyage

7-3 Government Actions and Capital Investment

1 Investment will increase because net cash flows will increase and more projects will meet DCF criteria Some students might ask about the value of depreciation deductions, which will fall, but after-tax cash flows from savings or higher sales will more than offset lower tax shields

2 Investment will increase because cost of capital will decrease More investments will meet companies’ capital budgeting criteria

3 Investments will increase because cash savings from depreciation will be immediate rather than spread out over the life of an asset You might wish

to discuss ACRS and MACRS at this point, perhaps pointing out that lives for tax purposes are significantly shorter than economic lives for most assets

4 Investment should increase as it becomes profitable to substitute capitalfor labor

5 Investments will increase because as labor becomes costlier, companies will substitute capital, just as in item 3 We tried to be very explicit about the effects in this question because we have used it as an exam

question and gotten disappointing results Most students say that

investments will decrease because the company will have less cash to invest, which ignores external financing

7-4 Capital Budgeting− Effects of Events

1 An increase in labor rates makes labor-cost-saving projects more

attractive, but makes increasing output less attractive Increasing output might still be attractive, but not as much as it would have been with lower labor costs

2 First, we have to assume that we will either reduce prices to meet the competition, or lose volume If we expect to hold prices and lose volume, cost-saving investments become less desirable because they affect fewer units(assuming that the savings are in variable costs) Certainly, decisions to increase output will be much less desirable because the volume will not be ashigh as originally forecast

If we meet the price reductions, decisions to increase output will be less desirable because the contribution margin from the additional sales will

be lower than otherwise Cost-reduction investments will probably be

unaffected

3 Investments that reduce costs become more attractive, because cost

reduction is critical in mature industries Investments that increase outputbecome less attractive because the volume increases will be less than

anticipated

7-5 Qualitative Concerns

General Note to the Instructor: The purposes of this and the following question are (a) to encourage students to think about both the quantitative and qualitative aspects of making decisions, and (b) to reduce students' concentration on the mechanics of specific analytical techniques The two questions should probably be considered together, since one deals with

rejecting a project that is economically acceptable while the other deals with accepting a project deemed economically unacceptable

We introduce capital rationing, sensitivity analysis, and mutually exclusive alternatives in Chapter 8 We leave to courses in managerial finance the task of discussing the significance and calculation of cost of capital and the use of risk-adjusted discount rates Nevertheless, we have found that, if pushed, most groups of students will come up with ideas

encompassing most of the problematic aspects of capital budgeting decisions not covered in the current chapter The list of reasons we offer below is not all-inclusive but generalizes the points made by past students

c The company might have many other projects with higher returns and not beable to fund all projects that are acceptable (Students are usually quick

to raise the issue of limited funds, or capital rationing.)

d The company might use other screens for its projects, such as a minimum IRR or a maximum payback period, and this project might not meet those

cutoffs (Chapter 8 suggests that a company might establish such cutoffs.)

2 The general note at the beginning also applies here, but this introduces some additional ideas

needed to round out its product line (This reason relates to an overall issue and could prevail even if analysis of the project gives full

consideration to complementary effects.)

b The project could involve a change in the manufacturing process to meet mandated pollution or hazardous-waste disposal guidelines (This answer assumes that reasonable alternatives for meeting the guidelines produce lowerIRRs, and that management has consciously decided the company should not abandon the area of its business affected by the mandated guidelines.)

c The project could involve improving employee relations (e.g., a

cafeteria, a recreation facility) or some other issue on which the company might have already committed itself to making changes with the expectation ofselecting projects with the "lowest cost." (A project showing a 20% IRR is clearly better than one showing an 8% return.)

d The project might advance an important strategy If the company's

reputation for high-quality products includes a role as an innovator, the project might be accepted to retain the company's competitive edge, despite the company's inability to quantify the advantages of maintaining that role

If reducing cycle time, or improving logistics, is critically important, the company might well accept a project that advances such a strategy, even without favorable numbers

e Managers might believe that the combination of an attractive payback period, relatively low risk, and their gross assessments of positive and negative nonquantifiable factors offsets its lower IRR (Most students are likely to come up with this technique-related answer.)

7-6 Discounting (15 minutes)

1 (a) About 12%

Investment $60,000

Divided by cash flow $12,000

Present value factor annuity of 8 years 5.000

Factor for 12% 4.968

(b) About 12%

Investment $120,000

Divided by cash flow $150,000

Present value factor, 2 years 800

Factor for 12% .797

2 (a) $9,500 [($30,000 x 5.650) - $160,000]

(b) Negative $3,436 [($8,000 x 3.037) + ($4,000 x 567) - $30,000]7-7 Discounting (10 minutes)

1 $34,050, the present value of $50,000 five years hence at 8% ($50,000

x 681)

2 $66,096, PV of a 4-year annuity of $20,400 at 9% ($10,200 x 3.240)

3 He should take the $700,000 lump sum because the present value of the annuity is only $671,000 ($100,000 x 6.710) Of course, if he lives longer,

he has a serious problem

4 $2,298,755 ($167,000 x 13.765, the factor for 30 periods at 6%)

7-8 Time Value of Money Relationships (10-15 minutes)

1 Just about $8,000 $12,880 x 621, the factor for 10% and 5 years

2 6 years $20,000/$54,000 = 370, the factor for 18% and 6 years

3 $45,640 $10,000 x 4.564, the factor for 12% and 7 years

4 4 years $100,000/$34,300 = 2.915 This factor is nearly equal to the factor for 14% and four years, 2.914

5 About $35,398, $200,000/5.65, the factor for 10 years at 12%

7-9 NPV and IRR Methods (10 minutes)

1 $2,220

Annual cash return $ 7,000 Times present value factor for 4-year annuity at 10% 3.170 Present value of flows $22,190 Less required investment 18,800 Net present value $ 3,390

2 A bit over 18%

Required investment $18,800 Divided by annual cash flow $ 7,000 Equals relevant PV factor for 4-year annuity 2.686

PV factor for 4-year annuity at 18% 2.6907-10 Basic Capital Budgeting Without Taxes (15 minutes)

1 $39,550

Cash Flow Cash savings $ 50,000 Present value factor, 5 years, 10% 3.791 Present value of future flows $189,550 Investment 150,000 Net present value $ 39,550

2 About 20% $150,000/$50,000 = 3.0 = factor for five years The

closest factor is 2.991, the factor for 20%

3 3.0 years, as calculated in requirement 2

4 27%, income of $20,000 ($50,000 - $30,000 depreciation) divided by

$75,000 average investment

Note to the Instructor: We stated that Ms Pawl wanted a 10% return from the business because an entrepreneur such as she would probably not speak of cost of capital or cutoff rates You might want to delve into how asmall business operator might make such judgments

7-11 Basic Capital Budgeting Taxes (Extension of 7-10) (15 minutes)

1 $16,804

Tax Cash Flow Pretax cash flow $50,000 $ 50,000 Depreciation ($150,000/5) 30,000 Increase in pretax income 20,000 Income tax at 30% $ 6,000 6,000 Net cash flow $ 44,000 Present value factor, 4 years, 10% 3.791 Present value of future flows 166,804 Investment 150,000 Net present value $ 16,804

2 About 14% $150,000/$44,000 = 3.409 = the factor for five years The closest factor is 3.433, for 14% The IRR is therefore a bit over 14%

3 3.41 years, as calculated in requirement 2

4 18.7%, income of $14,000 ($20,000 - $6,000) divided by the $75,000

Increase in pretax income 125,000

Income tax at 40% $ 50,000 50,000 Net cash flow $200,000 Present value factor, 12%, 4 years 3.037 Present value of future flows $607,400 Investment 500,000 Net present value $107,400

2 NPV increases $9,540, the present value of the after-tax cash from the

$25,000 residual value to be received 4 years hence ($25,000 x 60% x 636), since the company can ignore salvage value for depreciation

Note to the Instructor: This is a good time to remind the class that the sooner flows come in, the better The total tax savings from the asset are the same whether or not salvage value is included in the depreciation calculations But leaving salvage value out accelerates the savings, which are partly repaid when the gain is realized and taxed

7-13 Basic Capital Budgeting− Services (10-15 minutes)

1 $86,600

Cash Flow Cash operating savings $200,000 Present value factor, 5 years, 14% 3.433 Present value of future flows $686,600 Investment 600,000

Net present value $ 86,600

2 Nearly 20% The factor is 3.0 ($600,000/$200,000), which is closest to 2.991, the factor for 20% Because the 3.0 is greater than the 20% factor, the IRR is less than 20%

3 3 years, as calculated in requirement 2

4 About 27%, income of $80,000 ($200,000 - $120,000 depreciation) divided

Increase in pretax income 80,000

Income tax at 40% $ 32,000 32,000 Net cash flow 168,000 Present value factor, 14%, five years 3.433 Present value of future flows, rounded $ 576,740 Investment 600,000 Net present value ($ 23,260)

2 The IRR is a bit over 12% The factor is 3.571 ($600,000/$168,000), which

is closest to 3.605, the 12% factor

3 3.571 years, as calculated in requirement 2

4 16%, income of $48,000 ($80,000 - taxes of $32,000) divided by $300,000 average investment

$70,000/2 $35,000 $35,000 $35,000 Equals book rate of return 3.6% 28.6% 35.7% (c) B, C, A Investment B is the only one with a positive NPV

A B C

Present Present Present

Year Cash Flow Value Cash Flow Value* Cash Flow Value

* Present value factors are 862, 743, 641, and 552.

2 The results show that payback and book-rate-of-return rankings do not necessarily indicate relative profitability B is the only desirable

investment, using discounted cash flow analysis

Investment A illustrates that payback ignores profitability; the projecthas the quickest payback but little cash flow after the payback period Investment C has high income, but much of it comes in the last year, when thecash flow is worth less than it would have been earlier Investment C

returns more in total than does A, but the wait is too long to be worthwhile

at 16%

7-16 NPV (15-20 minutes)

Sites should acquire the machine because its NPV is $28,848

Tax Cash Flow Cost savings:

Current cost (40,000 x $0.80) $32,000 $32,000 Expected cash cost [$8,400 + (40,000 x $0.10)] 12,400 12,400 Annual savings $19,600 19,600 Depreciation ($20,000/5) 4,000

Pretax income 15,600

Tax at 30% $ 4,680 4,680 Net cash flow $14,920 Present value factor, 5 years, 16% 3.274 Present value of future flows $48,848 Less investment 20,000 Net present value $28,848

At least two nonquantitative factors might influence the decision The owner might view employing high school students as a contribution to the community and so be inclined not to purchase the new equipment However, with such a high NPV, it is unlikely that he would forego the purchase He would tend to favor the purchase even if it appeared marginally profitable,

if he had experienced problems finding reliable students

Note to the Instructor: This exercise has several purposes First, it requires students to determine the cost savings, information that is provided

in most other assignments Second, it forces consideration of qualitative issues in a setting students are likely to understand

7-17 Capital Budgeting for a Not-for-Profit (20 minutes)

a $138,880

Annual cash flow ($300,000 - $120,000) $180,000 Present value factor, 10 years, 14% 5.216 Present value of future flows $938,880 Investment 800,000 Net present value $138,880

b 4.44 years ($800,000/$180,000)

c About 18%, the factor for 18% is 4.494 for students using tables

7-18 Understanding IRR (15-20 minutes)

General Note to the Instructor: The purpose of this exercise is to

trace the flows so that the student can see why the IRR is the interest rate that brings the NPV to zero

1 $49,740, which is $20,000 x 2.487 (the factor for 10%, 3 years)

Increase in pretax income 150,000

Income tax at 40% $ 60,000 60,000 Net cash flow $ 340,000 Present value factor, 14%, 4 years 2.914 Present value of future flows 990,760 Investment 1,000,000 Net present value ($ 9,240)

2 About 13.5% from Lotus 1-2-3 The factor is 2.941 ($1,000,000/$340,000),which is close to the 2.914 factor for 14%

7-20 Relationships (20-25 minutes)

1 (d) 20%, the factor for 20%, 10 years is 4.192

Cost $188,640 Divided by annual cash flow $ 45,000 Present value factor for 10 years 4.192 (e) $46,080

Annual cash flow $ 45,000 Times the present value factor for 14%, 10 years 5.216 Present value of future cash flows $234,720 Less cost 188,640 Net present value $ 46,080

2 (b) $337,050

Annual cash flow $ 75,000 Times present value factor for 18%, 10 years 4.494 Cost $337,050 (e) $86,700

Annual cash flow $ 75,000 Times present value factor for 12%, 10 years 5.650 Present value of future cash flows $423,750 Less cost 337,050 Net present value $ 86,700

3 (a) $62,073

Cost $300,000

Divided by the present value factor, 16%, 10 years 4.833 Equals annual cash flow $ 62,073 (c) 10%, the factor for 10%, 10 years is 6.145.

Cost $300,000 Plus net present value 81,440 Total present value of future cash flows $381,440 Divided by annual cash flow $ 62,073 Equals present value factor for 10 years 6.145

4 (a) $100,000

Cost $450,000 Plus net present value 115,000 Total present value $565,000 Divided by present value factor for 12%, 10 years 5.650 Equals annual cash flow $100,000 (d) About 18%, the factor for 18%, 10 years is 4.494

Cost $450,000 Divided by annual cash flow $100,000 Equals present value factor for 10 years 4.5007-21 Comparison of Book Return and NPV (15-20 minutes)

1 The hand-fed machine has the higher book rate of return on average

investment

Hand-Fed Semiautomatic Revenue (200,000 x $10) $2,000,000 $2,000,000 Variable costs at $4, $2 800,000 400,000 Cash fixed costs 725,000 850,000 Depreciation ($800,000/4; $1,400,000/4) 200,000 350,000 Total costs 1,725,000 1,600,000 Pretax profit 275,000 400,000 Income tax at 40% 110,000 160,000 Net income $ 165,000 $ 240,000 Average investment

$800,000/2 $ 400,000

$1,400,000/2 $ 700,000 Book rate of return 41.25% 34.3%

2 The semiautomatic machine has the higher NPV

Hand-Fed Semiautomatic Net cash flows:

Net income $ 165,000 $ 240,000 Depreciation 200,000 350,000 Net cash flow $ 365,000 $ 590,000 Present value factor, 4 years, 14% 2.914 2.914 Present value $1,063,610 $1,719,260 Investment 800,000 1,400,000 Net present value $ 263,610 $ 319,260

3 The hand-fed machine has an IRR in excess of 25%; the semiautomatic machine's IRR is between 24% and 25%

Hand-Fed Semiautomatic Investment $ 800,000 $1,400,000 Divided by annual cash flows (part 2) $ 365,000 $ 590,000 Equals present value factor for 4 years 2.192 2.373 Closest factors:

25% 2.362 2.362 24% 2.404 Note to the Instructor: The above answer assumes students will limit their search for an answer to the tables available in the text IRR on the hand-fed machine is between 29% and 30%

7-22 Increasing Volume (15-20 minutes)

1 $2,780 thousand

Tax Cash Flow Contribution margin [(300 x ($90 - $65)] $ 7,500 $ 7,500 Fixed cash operating costs 4,200 4,200 Pretax cash flow 3,300 3,300

Depreciation ($8,000,000/4) 2,000

Increase in taxable income 1,300

Increased taxes (40%) $ 520 520

Increase in net cash flow $2,780 2 $443 thousand

Increase in annual cash flow (requirement 1) $ 2,780 Present value factor, 4 years, 12% 3.037 Present value of future cash flows $ 8,443 Investment 8,000 Net present value $ 443

3 14.6% from Lotus 1-2-3 For students using tables, the factor is 2.878 ($8,000/$2,780), which falls between the values for 14% and 16% 4 NPV increases by $229 thousand Salvage value $600

Less tax at 40% 240

Net cash flow 360

Times factor for 4 years at 12% 636

Equals present value of salvage value $229

7-23 Investing in JIT (15 minutes) $1,390 thousand Annual savings $ 800

Less tax, at 40% 320

Net flow $ 480

Present value factor, 30 years, 10% 9.427

Present value of flow $4,525 Tax shield ($4.5 million/5) $ 900

Tax rate 40%

Tax saving $ 360

Present value factor, 5 years, 10% 3.791 Present value of tax savings 1,365 Total present value of future flows 5,890 Less investment 4,500 Net present value $1,390

Note to the Instructor: This assignment doesn't get into the details ofbenefits that JIT provides, but it can serve as a basis for discussing JIT operations and how to measure some of their benefits The $800 thousand stated savings can come from any number of areas including lower material andlabor costs, and lower costs for such support activities as inspection, materials-handling, maintenance, and production scheduling Some of these costs are relatively easy to estimate and some are not Among the costs of quality that should drop are the costs of warranties, field engineering, and other elements that result from having less than superb quality

Other qualitative factors that managers should consider include higher productivity as workers become more involved and more satisfied, and higher sales because of increased quality The importance of any such factor

depends on how well the company was doing before In some cases the

incremental benefit could be quite high, in others relatively low

7-24 Safety Equipment (15 minutes)

1 The NPV is a negative $8,051

Tax Cash Flow Savings in premiums ($93,000 - $45,000) $48,000 $ 48,000 Depreciation ($200,000/10) 20,000 Increase in taxable income 28,000 Increased taxes at 40% $11,200 11,200 Increase in net cash flow 36,800 Present value factor, 10 years, 14% 5.216 Present value of future cash flows 191,949 Investment required 200,000 Net present value ($ 8,051)

2 The items covered in students' memos will differ, but the most likely recommendation is to install the equipment despite its negative NPV Memos should include some of the following items

(a) The analysis understates the cost savings because it does not consider the potential for liability claims if employees are injured (or worse) The analysis should include some estimate of the potential savings from not increasing the potential losses in lawsuits brought by injured employees (b) The increased potential for injury to employees should be, in itself, a consideration in the decision Moreover, the cost to the company is

relatively small (The cost of the new system is $200,000, suggesting a muchlarger value for the building and its contents, and this factory is only one

of several owned by the company.)

(c) Another factor to consider in connection with the increased potential for injury to employees is the potential for damage to the company's public image and reputation if the public became aware that the company refused to install new equipment

(d) The cost savings are likely to be understated by assuming that the premium differential this year applies to all future years If installation

of a new system is delayed, premiums might increase even further, and, at some point, coverage might not be available at virtually any price

Note to the Instructor: In this slight revision of a problem used in previous editions, we tried to make obvious the issue of risk of harm to employees by describing the insurance coverage and asking specifically about

"other" factors It's likely that a few students still will not recognize that issue Some who do see it will point out that $8,051 is a small price

to pay for a serious injury, let alone the life of even one employee Such

an assertion presents the opportunity for class discussion of the many

situations when efforts are made to place a value on a human life (e.g., court cases and allocations of funds available for medical services)

Students should be encouraged to avoid making quick personal judgments about the relative size of some known expenditure (or receipt) Such

judgments are especially to be avoided when, as indicated in the

parenthetical material in item (b), facts are available to support at least apreliminary assessment of relative magnitude In this case, a preliminary assessment reduces the need to address the more general and more difficult task of placing a specific value on human suffering Absent analytical evidence that the cost is "relatively small" for the entity in question, a student's assertion to that effect is a personal matter For example, had the negative NPV been, say, $200 million, individual judgments would surely have differed

Professor Don Lucy shared with us a suggestion by one of his students that the company tell employees it is spending $200,000 to make them safer 7-25 Employment Options (15-20 minutes)

1 Bob prefers the $2,000,000 for 10 years at his 10% discount rate

30 years 10 years Pretax flow $1,200,000 $2,000,000 Less tax at 30% 360,000 600,000 After-tax flow $ 840,000 $1,400,000 Present value factors 9.427 6.145 Present value $7,918,680 $8,603,000 Advantage to 10-year term = $684,320

2 The team prefers $1,200,000 for 30 years at its 14% discount rate

30 years 10 years Pretax flow $1,200,000 $2,000,000 Less tax at 40% 480,000 800,000 After-tax flow 720,000 1,200,000 Present value factors 7.003 5.216 Present value $5,042,160 $6,259,200 Advantage to 30-year term = $1,217,040

3 Bob wants a higher present value and the team wants a lower present value It's not surprising that their interests are opposed The team's higher discount rate leads it to prefer lower flows over a longer period, andits higher tax rate works in the same direction Even if they used the same discount rate, their responses could differ because of the tax differences Note to the Instructor: You might extend this assignment by asking whether the team might benefit by raising the 30-year payment so that Bob would prefer it to the 10-year term The 30-year payment that would make Bobindifferent between the choices is $325,926

Present value of 10-year payments (above) $8,603,000 Divided by Bob's present value factor for 30 years 9.427 Annual after-tax payment required $ 912,592 Divided by (1 - 30% tax rate) 70% Equals required payment $1,303,702 Present value of payment to team ($1,303,702 x 60 x 7.003) $5,477,898