CHAPTER 13

CAPITAL INVESTMENT DECISIONS

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, acceptance of one precludes the
acceptance of others.

11.

If NPV > 0, then the investment is acceptable. 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 resources 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 signals. IRR may be popular because it provides the correct signal most of the time and
managers are accustomed to working with
rates of return.

15.

6. The accounting rate of return is the average

income divided by original or average investment. ARR = $100,000/$300,000 =
33.33%

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.

7. Agree. Essentially, net present value is a

measure of the return in excess of the investment and its cost of capital.

NPV analysis is only as good as the accuracy of the cash flows. If projections of cash
flows are not accurate, then incorrect investment decisions may be made.

17.

The quality and reliability of the cash flow

projections are directly related to the assumptions and methods used for forecasting. If the assumptions and methods are
faulty, then the forecasts will be wrong, and
incorrect decisions may be made.

18.

The principal tax implications that should be

considered in Year 0 are gains and losses
on the sale of existing assets.

19.

The MACRS method provides more shielding effect in earlier years than the straightline method does. As a consequence, the
present value of the shielding benefit is
greater for the MACRS method.

2. The timing and quantity of cash flows determine the present value of a project. The
present value is critical for assessing whether 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) Obsolescence. If the risk of obsolescence is high,
firms will want to recover funds quickly. (c)
Self-interest. Managers want quick paybacks so that short-run performance measures are affected positively, enhancing
chances for bonuses and promotion. Also,
this method is easy to calculate.

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.
10.

For NPV, the required rate of return is the

discount rate. For IRR, the required rate of
return is the benchmark against which the
IRR is compared to determine whether an
investment is acceptable or not.

425

20.

21.

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.

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
years depreciation can be claimed, regardless 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.

22.

Intangible and indirect benefits are of much

greater importance in the advanced manufacturing environment. Greater quality, more
reliability, improved delivery, and the ability

426

Sensitivity analysis changes the assumptions on which the capital investment analysis 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 future events.

EXERCISES
131
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

12.
13.
14.
15.
16.
17.
18.
19.
20.

a
e
c
a
d
e
c
b
d
e
b

c
a
e
c
a
e
b
e
c

132
1.

Payback period = $200,000/$60,000 = 3.33 years

2.

Payback period:
$125,000 1.0 year
175,000 1.0 year
200,000 0.8 year
$500,000 2.8 years

3. Investment = annual cash flow payback period

= $120,000 3
= $360,000

4. Annual cash flow = Investment/payback period

= $250,000/2.5
= $100,000 per year

427

133
1.
Initial investment (Average depreciation = 300,000):
Accounting rate of return = Average accounting income/Investment
= ($2,500,000 $2,000,000 - $300,000)/$1,500,000
= 13.3%

2. Accounting rate of return (ARR):

Project A: ARR = ($12,800 $4,000)/$20,000 = 44%
Project B: ARR = ($7,600 $2,000)/$20,000 = 18%
Project A should be chosen.
3. ARR = Average Net Income/Average Investment
0.25 = $100,000/Average Investment
Average Investment = $100,000/0.25
= $400,000
Thus, Investment = 2 $400,000
= $800,000
4. ARR = Average Net Income/Investment
0.50 = Average Net Income/$200,000
Average Net Income = 0.50 $200,000
= $100,000

134
1.

NPV = P I
= (5.650 $240,000) $1,360,000
= $(4,000)
The system should not be purchased.

2. NPV = P I
= (4.623 $9,000) $30,000 = $11,607
Yes, he should make the investment.

428

3. NPV = P - I
I = P NPV
I = 4.355 $10,000 - $3,550
= $40,000
135
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:

Year
0
1
2
3
4
5
NPV

Cash Flow
$(200,000)
120,000
100,000
80,000
40,000
20,000

Discount Factor
1.000
0.893
0.797
0.712
0.636
0.567

429

Present Value
$(200,000)
107,160
79,700
56,960
25,440
11,340
$ 80,600

13-6 Concluded
Lawton Blood Analysis Equipment:
Year
0
1
2
3
4
5
NPV

Cash Flow
$(200,000)
20,000
20,000
120,000
160,000
180,000

Discount Factor
1.000
0.893
0.797
0.712
0.636
0.567

Present Value
$(200,000)
17,860
15,940
85,440
101,760
102,060
$ 123,060

2. CF(df) I = NPV
CF(3.605) - $200,000 = $123,060
(3.605)CF = $323,060
CF = $323,060/3.605
CF = $89,614 per year
Thus, the annual cash flow must exceed $89,614 to be selected.
137
1.

Payback period = Original investment/Annual cash inflow

= $800,000/($1,300,000 $1,000,000)
= $800,000/$300,000
= 2.67 years

2.

a.

Initial investment (Average depreciation = 160,000):

Accounting rate of return = Average accounting income/Investment
= ($300,000 $160,000)/$800,000
= 17.5%

430

13-7 Concluded

3.

Year
0
1
2
3
4
5
NPV

4.

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

Cash Flow
$(800,000)
300,000
300,000
300,000
300,000
300,000

Discount Factor
1.000
0.909
0.826
0.751
0.683
0.621

Present Value
$(800,000)
272,700
247,800
225,300
204,900
186,300
$ 337,000

df = Investment/Annual cash flow

= $800,000/$300,000
= 2.67
For five years and a discount factor of 2.67, the IRR is between 24 and
26%.
13-8

1.

Payback period:
Project A:
$ 3,000
4,000
3,000
$10,000

1.00 year
1.00 year
0.60 year
2.60 years

Project B:
$ 3,000
4,000
3,000
$10,000

1.00 year
1.00 year
0.50 year
2.50 years

Both projects have about the same payback so the most profitable
should be chosen (Project A).

431

13-8
2.

Concluded

Accounting rate of return (ARR):

Project A: ARR = ($6,400 $2,000)/$10,000 = 44%
Project B: ARR = ($3,800 $2,000)/$10,000 = 18%
Project A should be chosen.

3.

P = 9.818 $24,000 = $235,632

Wilma should take the annuity.

4.

NPV = P I
= (4.623 $6,000) $20,000 = $7,738
Yes, he should make the investment.

5.

df = $130,400/$25,000 = 5.216
IRR = 14%
Yes, the investment should be made.

139
1.

a. Return of the original investment

b. Cost of capital ($200,000 10%)
c. Profit earned on the investment
($231,000 $220,000)

$200,000
20,000
11,000

Present value of profit:

P = F Discount factor
= $11,000 0.909
= $9,999
2.

Cash Flow
Year
0
$(200,000)
1
231,000
Net present value

Discount Factor
1.000
0.909

Present Value
$(200,000)
209,979
$
9,979

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

432

1310
1.

Bond cost = $6,000/$120,000 = 0.05

Cost of capital

2.

= 0.05(0.6) + 0.175(0.4)
= 0.03 + 0.07
= 0.10

Year
Cash Flow
0
$(200,000)
1
100,000
2
100,000
3
100,000
Net present value

Discount Factor
1.000
0.909
0.826
0.751

Present Value
$(200,000)
90,900
82,600
75,100
$ 48,600

It is not necessary to subtract the interest payments and the dividend payments because these are associated with the cost of capital and are included
in the firms cost of capital of 10 percent.

433

1311
1.

P = I = df CF
2.914* CF = $120,000
CF = $41,181
*From Exhibit 13B-2, 14 percent for four years

2.

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

I = df CF
= 2.402 CF (1)
For NPV:
NPV = df CF I
= 2.577 CF I (2)
Substituting equation (1) into equation (2):
NPV = (2.577 CF) (2.402 CF)
$1,750 = 0.175 CF
CF = $1,750/0.175
= $10,000 in savings each year
Substituting CF = $10,000 into equation (1):
I = 2.402 $10,000
= $24,020 original investment

3.

For IRR:
I = df CF
$60,096 = df $12,000
df = $60,096/$12,000
= 5.008
From Exhibit 13B-2, 18 percent column, the year corresponding to df = 5.008
is 14. Thus, the lathe must last 14 years.

434

1311 Concluded
4.

X = Cash flow in Year 4

Investment = 2X
Year
0
1
2
3
4
NPV

Cash Flow
$
(2X)
10,000
12,000
15,000
X

Discount Factor
1.000
0.909
0.826
0.751
0.683

2X + $9,090 + $9,912 + $11,265 + 0.683X

1.317X + $30,267
1.317X
X
Cash flow in Year 4 = X = $20,000
Cost of project = 2X = $40,000

435

= $3,927
= $3,927
= ($26,340)
= $20,000

Present Value
$
(2X)
9,090
9,912
11,265
0.683X
$ 3,927

1312
1.

NPV:
Project I
Year
0
1
2
NPV

Cash Flow
$(100,000)

134,560

Discount Factor
1.000

0.826

Present Value
$(100,000)

111,147
$ 11,147

Cash Flow
$(100,000)
63,857
63,857

Discount Factor
1.000
0.909
0.826

Present Value
$(100,000)
58,046
52,746
$ 10,792

Project II
Year
0
1
2
NPV

Project I should be chosen using NPV.

IRR:
Project I
I
$100,000
(1 + i)2
1+I
IRR

= df CF
= $134,560/(1 + i)2
= $134,560/$100,000
= 1.3456
= 1.16
= 16%

Project II
df = I/CF
= $100,000/$63,857
= 1.566
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 profitability. Thus, since NPV reveals the total wealth change attributable to each
project, it is preferred to the IRR measure.

436

1313
Project A:
CF = NI + Noncash expenses
= $54,000 + $45,000
= $99,000
Project B:
CF = [(1 t) Cash expenses] + [t Noncash expenses]
= (0.6 $90,000) + (0.4 $15,000)
= $48,000

1314
1.

Year
1
2
3
4
NPV

Depreciation
$2,000
4,000
4,000
2,000

tNC
$ 800
1,600
1,600
800

df
0.893
0.797
0.712
0.636

Present Value
$ 714
1,275
1,139
509
$3,637

2.

Year
1
2
3
4
NPV

Depreciation
$4,000
5,334
1,777
889

tNC
$1,600
2,134
711
356

df
0.893
0.797
0.712
0.636

Present Value
$1,429
1,701
506
226
$3,862

3.

MACRS increases the present value of tax shielding by increasing the amount
of depreciation in the earlier years.

437

1315
Purchase (assumes MACRS depreciation):
Year
0
1
2
3
4
5
NPV

(1 t)C

$(3,000)a
(3,000)
(3,000)
(3,000)
(3,000)

tNC

$2,400b
3,840c
2,304d
1,382e
1,382e

CF
$(30,000)
(600)
840
(696)
(1,618)
(1,618)

df
1.000
0.909
0.826
0.751
0.683
0.621

$5,000 0.6
$30,000 0.2 0.4
c
$30,000 0.32 0.4
d
$30,000 0.192 0.4
e
$30,000 0.1152 0.4
b

Lease:
Year
0
15
5
NPV

(1 t)C
$(7,500)*

CF
$(1,000)
(7,500)
1,000

df
1.000
3.791
0.621

P
$ (1,000)
(28,433)
621
$ (28,812)

*$12,500 0.6
The car should be leased because leasing has a lower cost.

438

P
$(30,000)
(545)
694
(523)
(1,105)
(1,005)
$(32,484)

1316
1.

Standard equipment (Rate = 18%):

Year
0
1
2
310
NPV

Cash Flow
$(500,000)
300,000
200,000
100,000

df
1.000
0.847
0.718
2.928

Present Value
$(500,000)
254,100
143,600
292,800
$ 190,500

Cash Flow
$(2,000,000)
100,000
200,000
300,000
400,000
500,000
1,000,000

df
1.000
0.847
0.718
0.609
1.323
0.314
0.682

Present Value
$(2,000,000)
84,700
143,600
182,700
529,200
157,000
682,000
$ (220,800)

Standard equipment (Rate = 10%):

Year
Cash Flow
0
$(500,000)
1
300,000
2
200,000
310
100,000
NPV

df
1.000
0.909
0.826
4.409

Present Value
$(500,000)
272,700
165,200
440,900
$ 378,800

df
1.000
0.909
0.826
0.751
1.868
0.513
1.277

Present Value
$(2,000,000)
90,900
165,200
225,300
747,200
256,500
1,277,000
$ 762,100

CAM equipment (Rate = 18%):

Year
0
1
2
3
46
7
810
NPV
2.

CAM equipment (Rate = 10%):

Year
0
1
2
3
46
7
810
NPV

Cash Flow
$(2,000,000)
100,000
200,000
300,000
400,000
500,000
1,000,000

439

1316 Concluded
3.

Notice how the cash flows using a 10 percent rate in Years 810 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.

1317
1.

Standard equipment (Rate = 14%):

Year
0
1
2
310
NPV

Cash Flow
$(500,000)
300,000
200,000
100,000

df
1.000
0.877
0.769
3.571

Present Value
$(500,000)
263,100
153,800
357,100
$ 274,000

df
1.000
0.877
0.769
0.675
1.567
0.400
0.929

Present Value
$(2,000,000)
87,700
153,800
202,500
626,800
200,000
929,000
$ 199,800

df
1.000
0.877
0.769
3.571

Present Value
$(500,000)
263,100
153,800
178,550
$ 95,450

CAM equipment (Rate = 14%):

Year
0
1
2
3
46
7
810
NPV
2.

Cash Flow
$(2,000,000)
100,000
200,000
300,000
400,000
500,000
1,000,000

Standard equipment (Rate = 14%):

Year
0
1
2
310
NPV

Cash Flow
$(500,000)
300,000
200,000
50,000

The decision reversesthe 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 emphasizes how intangible benefits can affect decisions.

440

PROBLEMS
1318
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 return 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 assumes 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 projects 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 projects profitability. Project B is better than Project A for
both of these measures.

441

1318 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 companys competitiveness or image if it does
not make the investment.
Risks inherent in the project, business, or country for the investment.

1319
1.

Schedule of cash flows:

Year
0
17

Item

Cash Flow

Equipment
Working capital

$(300,000)
(30,000)

Cost savings
Equipment operating costs

Overhaul

Salvage value
Recovery of working capital

$135,000
(60,000)

(30,000)
24,000
30,000

NPV:
Year
0
17
5
7
NPV

Cash Flow
$(330,000)
75,000
(30,000)
54,000

75,000

df
1.000
4.868
0.621
0.513

Present Value
$(330,000)
365,100
(18,630)
27,702
$ 44,172

Yes, the new process design should be accepted.

442

1320

1.

Schedule of cash flows:

Year

Item

Cash Flow

Equipment
Working capital
Total

$(1,100,000)
(50,000)
$(1,150,000)

15

Revenues
Operating expenses
Total

$ 1,500,000
(1,260,000)
$ 240,000

Revenues
Operating expenses
Major maintenance
Total

$ 1,500,000
(1,260,000)
(100,000)
$ 140,000

79

Revenues
Operating expenses
Total

$ 1,500,000
(1,260,000)
$ 240,000

10

Revenues
Operating expenses
Salvage
Recovery of working capital
Total

$ 1,500,000
(1,260,000)
40,000
50,000
$ 330,000

443

13-20
2.

Concluded

Year
0
15
6
7
8
9
10
NPV

Cash Flow
$(1,150,000)
240,000
140,000
240,000
240,000
240,000
330,000

Discount Factor
1.000
3.605
0.507
0.452
0.404
0.361
0.322

Present Value
$(1,150,000)
865,200
70,980
108,480
96,960
86,640
106,260
$ 184,250

The product should be produced.

13-21
1.

df = Investment/Annual cash flow

= $96,660/$20,000
= 4.833
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
CF = $15,730
*Discount factor at 10 percent (cost of capital) for ten years

3.

For a life of eight years:

df = I/CF
= $96,660/$20,000
= 4.833
The IRR is between 12 percent and 14 percentgreater than the 10
percent cost of capital. The company should still acquire the new system.

444

13-21

Concluded

Minimum cash flow at 10 percent for eight years:

I = df CF
$96,660 = 5.335 CF
5.335 CF = $96,660
CF = $18,118
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 latter 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.

1322
1.

The IRR using the best estimates:

Selling price
Unit variable cost
Unit contribution margin

Per unit
$10
4
$ 6

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

Less: Fixed costs
Annual cash flow

$ 6,000,000
2,000,000
$ 4,000,000

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:
Per unit
90% of selling price
$9
Unit variable cost
4
Contribution margin
$5
Total contribution margin ($5 1,000,000 annual sales volume) $5,000,000
Less: Fixed costs
2,000,000
Annual cash flow
$3,000,000

445

1322 Concluded
Discount factor = $12,000,000/$3,000,000 = 4.00, which implies an IRR that
is approximately 8 percent.
b. If the per-unit sales volume is reduced 10 percent, the adjusted IRR is 13
percent, as calculated below:
Per unit
Selling price
$10
Unit variable cost
4
Contribution margin
$ 6
Total contribution margin ($6 900,000 annual sales volume)
Less: Fixed costs
Annual cash flow

$5,400,000
2,000,000
$3,400,000

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:
Per unit
Selling price
$10.00
Unit variable cost
3.60
Contribution margin
$ 6.40
Total contribution margin
($6.40 1,000,000 annual sales volume)
Less: Fixed costs
Annual cash flow

$6,400,000
2,000,000
$4,400,000

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 assumptions 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 values possible with their probability of occurrence are important information. It
also ignores the fact that assumptions are dynamic and can interact with
each other.

446

1323
1.

First, calculate the expected cash flows:

Days of operation each year: 365 15 = 350
Revenue per day: $200 2 150 = $60,000
Annual revenue: $60,000 350 = $21,000,000
Annual cash flow = Revenues Operating costs
= $21,000,000 $2,500,000
= $18,500,000
NPV = P I
= (6.623 $18,500,000) $100,000,000
= $122,525,500 $100,000,000
= $22,525,500
Yes, the aircraft should be purchased.

2.

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

= $14,300,000
NPV = P I
= (6.623 $14,300,000) $100,000,000
= $(5,291,100)
No, the aircraft should not be purchased.

3.

NPV = (6.623)CF $100,000,000 = 0

CF = $100,000,000/6.623
= $15,098,898
Annual revenue = $15,098,898 + $2,500,000
= $17,598,898
Daily revenue = $17,598,898/350
= $50,283
Seats to be sold = $50,283/$400
= 126 seats (each way)
Seating rate needed = 126/150 = 84%

447

1323 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 interval, suggesting a high probability of a positive NPV.

1324
1.

1.00 year
1.00 year
1.00 year
0.13 year*
3.13 years

$16,800
24,000
29,400
3,800
$74,000

*$3,800/$29,400
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
= $24,900
Average depreciation = ($74,000 $6,000)/4 = $17,000
Accounting rate of return = ($24,900 $17,000)/$74,000
= $7,900/$74,000
= 10.7%
Accounting rate of return using average investment:
Accounting rate of return = $7,900/$40,000*
= 19.8%
*Average investment = (Investment + Salvage)/2
= ($74,000 + $6,000)/2

448

1324 Concluded
3.

Year
0
1
2
3
4
NPV

Cash Flow
$(74,000)
16,800
24,000
29,400
35,400*

Discount Factor
1.000
0.893
0.797
0.712
0.636

Present Value
$(74,000)
15,002
19,128
20,933
22,514
$ 3,577

Discount Factor
1.000
0.877
0.769
0.675
0.592

Present Value
$(74,000)
14,734
18,456
19,845
20,957
$
(8)

*Includes $6,000 salvage value

IRR (by trial and error):
Using 14 percent as the first guess:
Cash Flow
Year
0
$(74,000)
1
16,800
2
24,000
3
29,400
4
35,400
NPV
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
0
1
2
3
4
NPV

Cash Flow
$(74,000)
11,200
16,000
19,600
25,600

Discount Factor
1.000
0.893
0.797
0.712
0.636

Present Value
$(74,000)
10,002
12,752
13,955
16,282
$(21,009)

For Years 14, 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.

449

1325
Keep old computer:
Year
0
1
2
3
4
5
NPV

(1 t)Ra

$6,000

(1 t)Cb

$(60,000)
(60,000)
(60,000)
(60,000)
(60,000)

tNCc

$32,000
32,000
16,000

CF

$(28,000)
(28,000)
(44,000)
(60,000)
(54,000)

df

0.893
0.797
0.712
0.636
0.567

Present Value

$ (25,004)
(22,316)
(31,328)
(38,160)
(30,618)
$(147,426)

(0.60) $10,000
(0.60) $100,000
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 =
$80,000.
b

Buy new computer:

a

Yr. (1 t)R (1 t)C

0
1
(30,000)
2
(30,000)
3
(30,000)
4
(30,000)
5 $42,720 (30,000)
NPV

tNC
$60,000
40,000
64,000
38,400
23,040
23,040

Other
$(450,000)

28,800

CF
$(390,000)
10,000
34,000
8,400
(6,960)
64,560

df
1.000
0.893
0.797
0.712
0.636
0.567

Present
Value
$(390,000)
8,930
27,098
5,981
(4,427)
36,606
$(315,812)

(0.60) ($100,000 Book value), where book value = $500,000 $471,200

(0.60) $50,000
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 15: 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 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.
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 accumulated depreciation).
b

The old computer should be kept since it has a lower cost.

450

1326
1.

Purchase:
Year
0
1
2
3
4
5
6
7
8
9
10

(1 t)Ra

(1 t)Cb

tNCc

$33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
45,000d

$(12,000)
(12,000)
(12,000)
(12,000)
(12,000)
(12,000)
(12,000)
(12,000)
(12,000)
(12,000)

$5,716
9,796
6,996
4,996
3,572
3,568
3,572
1,784

Cash Flow
$(100,000)
26,716
30,796
27,996
25,996
24,572
24,568
24,572
22,784
21,000
33,000

0.60 $55,000
0.60 $20,000
c
0.40 0.1429 $100,000, 0.40 0.2449 $100,000, etc.
d
Includes salvage value as a gain.
b

Leasewith service contract:

Year
0
1
2
3
4
5
6
7
8
9
10

(1 t)R
$33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000

(1 t)Ca
$(12,420)
(18,420)
(18,420)
(18,420)
(18,420)
(18,420)
(18,420)
(18,420)
(18,420)
(18,420)
(6,000)

tNCb
$1,200
1,200
1,200
1,200
1,200
1,200
1,200
1,200
1,200
1,200

Cash Flow
$(47,420)c
15,780
15,780
15,780
15,780
15,780
15,780
15,780
15,780
15,780
33,200d

Year 0: 0.60 $20,700; Years 19: 0.60 $30,700; Year 10: 0.60 $10,000
0.40 $3,000
c
Includes deposit of $5,000 and purchase of contract of $30,000
d
Includes the refund of the $5,000 deposit
b

451

1326 Continued
Leasewithout service contract:
Year
0
1
2
3
4
5
6
7
8
9
10

(1 t)R
$33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000
33,000

(1 t)Ca
$(12,420)
(24,420)
(24,420)
(24,420)
(24,420)
(24,420)
(24,420)
(24,420)
(24,420)
(24,420)
(12,000)

Cash Flow
$(17,420)b
8,580
8,580
8,580
8,580
8,580
8,580
8,580
8,580
8,580
26,000c

Year 0: 0.60 $20,700; Years 19: 0.60 $40,700; Year 10: 0.60 $20,000
Includes deposit of $5,000
c
Includes return of $5,000 deposit
b

2.

Purchase:
Year
0
1
2
3
4
5
6
7
8
9
10
NPV

Cash Flow
$(100,000)
26,716
30,796
27,996
25,996
24,572
24,568
24,572
22,784
21,000
33,000

Discount Factor
1.000
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270

452

Present Value
$(100,000)
23,430
23,682
18,897
15,390
12,753
11,203
9,829
7,997
6,468
8,910
$ 38,559

1326 Concluded
Leasewithout service contract:
Year
0
19
10
NPV

Cash Flow
$(17,420)
8,580
26,000

Discount Factor
1.000
4.946
0.270

Present Value
$ (17,420)
42,437
7,020
$ 32,037

The equipment should be purchased.

It was not necessary to include all of the costs and revenues for each alternative. The operating revenues and operating costs could have been eliminated
because they are exactly the same for both alternatives and, thus, not relevant.
3.

Leasewith service contract:

Year
0
19
10
NPV

Cash Flow
$(47,420)
15,780
33,200

Discount Factor
1.000
4.946
0.270

Present Value
$ (47,420)
78,048
8,964
$ 39,592

The equipment should now be leased. Since the revenues of $55,000 per year
are the same for both alternatives, they could be excluded from the analysis.

453

1327
1.

Scrubbers and Treatment Facility (expressed in thousands):

Year
0
1
2
3
4
5
6
NPV

(1 t)Ra

(1 t)Cb

$3,000
3,000
3,000
3,000
3,000
3,600d

$(7,200)
(7,200)
(7,200)
(7,200)
(7,200)
(7,200)

tNCc
$2,000
3,200
1,920
1,152
1,152
576

CF
$(25,000)
(2,200)
(1,000)
(2,280)
(3,048)
(3,048)
(3,024)

df
1.000
0.909
0.826
0.751
0.683
0.621
0.564

Present Value
$(25,000)
(2,000)
(826)
(1,712)
(2,082)
(1,893)
(1,706)
$(35,219)

0.6 $5,000,000
0.6 $12,000,000
c
Year 1: 0.4 0.2 $25,000,000; Year 2: 0.4 0.32 $25,000,000; Year 3: 0.4
0.192 $25,000,000; Years 4 and 5: 0.4 0.1152 $25,000,000; Year 6: 0.4
0.0576 $25,000,000
d
Includes salvage value (0.6 $1,000,000)
b

Process Redesign (expressed in thousands):

Year
0
1
2
3
4
5
6
NPV

(1 t)Ra

(1 t)Cb

$9,000
9,000
9,000
9,000
9,000
9,900d

$(3,000)
(3,000)
(3,000)
(3,000)
(3,000)
(3,000)

tNCc
$4,000
6,400
3,840
2,304
2,304
1,152

CF
$(50,000)
10,000
12,400
9,840
8,304
8,304
8,052

df
1.000
0.909
0.826
0.751
0.683
0.621
0.564

Present Value
$ (50,000)
9,090
10,242
7,390
5,672
5,157
4,541
$ (7,908)

0.6 $15,000,000
0.6 $5,000,000
c
Year 1: 0.4 0.2 $50,000,000; Year 2: 0.4 0.32 $50,000,000; Year 3: 0.4
0.192 $50,000,000; Years 4 and 5: 0.4 0.1152 $50,000,000; Year 6: 0.4
0.0576 $50,000,000
d
Includes salvage value (0.6 $1,500,000)
b

The process redesign option is less costly and should be implemented.

454

1327 Concluded
2.

The modification will add to the cost of the scrubbers and treatment facility
(present value is 0.751 $4,000,000 = $3.004 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
$15.02 and $22.53 million to the first (second) alternative (0.751 $20,000,000
and 0.751 $30,000,000). 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.

1328
1.

Original savings and investment:

(14 percent rate):
Year
CF
0 $(45,000,000)
120 $4,000,000
20
5,000,000
NPV

df
1.000
6.623
0.073

Present Value
$(45,000,000)
26,492,000
365,000
$(18,143,000)

455

13-28

Continued

(20 percent rate):

Year
CF
0 $(45,000,000)
120 $4,000,000
20
5,000,000
NPV

2.

df
1.000
4.870
0.026

Present Value
$(45,000,000)
19,480,000
130,000
$(25,390,000)

Total benefits: ($4,000,000 + $1,000,000 + $2,400,000)

(14 percent rate):
Year
0
120
20
NPV

CF
df
$(45,000,000) 1.000
7,400,000 6.623
5,000,000 0.073

Present Value
$(45,000,000)
49,010,200
365,000
$ 4,375,200

(20 percent rate):

Year
0
120
20
NPV

CF
df
$(45,000,000) 1.000
7,400,000 4.870
5,000,000 0.026

Present Value
$(45,000,000)
36,038,000
130,000
$ (8,832,000)

456

13-28
3.

Concluded

Analysis with increased investment:

Year
CF
df
Present Value
0
$(48,000,000) 1.000
$(48,000,000)
120
7,400,000 6.623
49,010,200
20
5,000,000 0.073
365,000
NPV
$ 1,375,200
(20 percent rate):
Year
0
120
20
NPV

4.

CF
df
$(48,000,000) 1.000
7,400,000 4.870
5,000,000 0.026

Present Value
$(48,000,000)
36,038,000
130,000
$ (11,832,000)

The automated plant is an attractive investment when the additional

benefits are consideredit promises to return at least the cost of capital (even for the high-cost scenario). Using the hurdle rate of 20 percent is probably too conservativeespecially given the robustness of
the outcome using the cost of capital. The company should invest in
the new system.

1329
1.

Year
0
1
25
6
7
8
NPV

Cash Flow*
$(860,000)
196,400
230,800
196,400
162,000
162,000

Discount Factor
1.000
0.862
2.412
0.410
0.354
0.305

Present Value
$(860,000)
169,297
556,690
80,524
57,348
49,410
$ 53,269

*After-tax cash flow = (0.60 $270,000) + (0.40 annual depreciation) for

Years 16. Depreciation = $860,000/5 = $172,000 with taken in Year 1 and
taken in Year 6.

457

1329 Concluded
2.

Year
0
1
25
6
7
8
NPV

Cash Flow*
$(920,000)
186,800
223,600
186,800
150,000
150,000

Discount Factor
1.000
0.862
2.412
0.410
0.354
0.305

Present Value
$(920,000)
161,022
539,323
76,588
53,100
45,750
$ (44,217)

*After-tax cash flow = (0.60 $250,000) + (0.40 annual depreciation) for

Years 16. Depreciation = $920,000/5 = $184,000 with taken in Year 1 and
taken in Year 6.
After the fact, the decision was not a good one.
3.

The $100,000 per year is an annuity that produces an after-tax cash flow of
$60,000 ($100,000 0.60). The present value of this annuity is $260,640 (4.344
$60,000). This restores the project to a positive NPV position ($260,640
$44,217 = $216,423).

4.

A postaudit can help ensure that a firms resources are being used wisely. It
may reveal that additional resources ought to be invested or that corrective
action be taken so that the performance of the investment is improved. A
postaudit may even signal the need to abandon a project or replace it with a
more viable alternative. Postaudits also provide information to managers so
that their future capital decision making can be improved. Finally, postaudits
can be used as a means to hold managers accountable for their capital investment decisions.

458

1330
1.

Old system (dollars in thousands):

Year
0
19
10
NPV

(1 t)Ra

(1 t)Cb

tNCc

$18,000
18,000

$(13,440)
(13,440)

$240

Cash Flow
$
0
4,800
4,560

df
1.000
4.303
0.191

Present Value*
$
0
20,654
871
$ 21,525

Cash Flow
$(50,040)
12,840

df
1.000
4.494

Present Value*
$ (50,040)
57,703
$ 7,663

0.6 $300 100,000

0.6 $224 100,000
c
0.4 $600,000
*Rounded
b

New system (dollars in thousands):

Year
0
110
NPV
a

(1 t)Ra

(1 t)Cb

$18,000

$(7,320)

Direct materials (0.75 $80)

Direct labor (1/3 $90)
Volume-related OH ($20 $5)
Direct FOH ($34 $17)
Unit cost

tNCc
$2,160
$ 60
30
15
17
$122

Total cash expenses = $122 100,000 = $12,200,000

After-tax cash expenses = 0.6 $12,200,000
b

Year 0: Tax savings on loss from sale of old machine =

0.4 ($6,000,000 $600,000 $3,000,000) = $960,000
Years 110: Depreciation = 0.4 $54,000,000/10
c

Net outlay = $54,000,000 $3,000,000 $960,000 = $50,040,000

The company should keep the old system.

459

1330 Continued
2.

Old system (dollars in thousands):

Year
0
19
10
NPV

(1 t)R

(1 t)C

tNC

$18,000
18,000

$(13,440)
(13,440)

$240

Cash Flow
$
0
4,800
4,560

df
1.000
5.328
0.322

Present Value*
$
0
25,574
1,468
$ 27,042

Cash Flow
$(50,040)
12,840

df
1.000
5.650

Present Value
$ (50,040)
72,546
$ 22,506

New system (dollars in thousands):

Year
0
110
NPV

(1 t)R

(1 t)C

$18,000

$(7,320)

tNC
$2,160

Notice how much more attractive the automated system becomes when the
cost of capital is used as the discount rate.
*Rounded
3.

Old system with declining sales (dollars in thousands):

Year
0
1
2
3
4
5
6
7
8
9
10
NPV

(1 t)R

(1 t)C

tNC

$18,000
16,200
14,400
12,600
10,800
9,000
7,200
5,400
3,600
1,800

$(13,440)
(12,300)
(11,160)
(10,020)
(8,880)
(7,740)
(6,600)
(5,460)
(4,320)
(3,180)

$240
240
240
240
240
240
240
240
240

Cash Flow
$
0
4,800
4,140
3,480
2,820
2,160
1,500
840
180
(480)
(1,380)

df
Present Value**
1.000
$
0
0.893
4,286
0.797
3,300
0.712
2,478
0.636
1,794
0.567
1,225
0.507
761
0.452
380
0.404
73
0.361
(173)
0.322
(444)
$13,680

*Cash expenses = Fixed + Variable

= $3,400,000 (Direct fixed) + $190X
where X = Units sold
After-tax cash expense = $2,040,000 + $114X (0.6 formula above)
**Rounded

460

1330 Concluded
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 $22,506,000 to $23,278,800 (an increase of 0.322 $2,400,000), making the new investment more attractive. The
NPV analysis for the old system remains unchanged.

5.

Requirement 2 illustrates the importance of using the correct discount rate.

The rate of 18 percent made the automated alternative look totally unappealing. By using the correct rate, the alternative showed a large net present value, although it was still less than the NPV of the old system. The old systems
projections of future revenues, however, were overly optimistic. The old system was not able to produce the same level of quality as the new system and
took longer to producefactors that, when taken together, would reduce the
competitive position of the firm and cause sales to decline. When this effect
was considered (with the correct discount rate), the new system dominated
the old. Inclusion of salvage value simply increased this dominance.

1331
1.

Old operating system:

Year
0
110
NPV

Cash Flow*
$
0
(197,000)

df
1.000
5.650

Present Value
$
0
(1,113,050)
$(1,113,050)

*[(0.66 $350,000) + (0.34 $100,000)]

461

1331 Continued
Flexible system (using MACRS depreciation):
Year
0
1
2
3
4
5
6
7
8
9
10
NPV

(1 t)Ca

$(62,700)
(62,700)
(62,700)
(62,700)
(62,700)
(62,700)
(62,700)
(62,700)
(62,700)
(62,700)

tNCb

$ 60,733
104,083
74,333
53,083
37,953
37,910
37,953
18,955

Cash Flow
$(1,250,000)
(1,967)
41,383
11,633
(9,617)
(24,747)
(24,790)
(24,747)
(43,745)
(62,700)
(62,700)

df
1.000
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322

Present Value*
$(1,250,000)
(1,757)
32,982
8,283
(6,116)
(14,032)
(12,569)
(11,186)
(17,673)
(22,635)
(20,189)
$(1,314,892)

$95,000 0.66
$1,250,000 0.1429 0.34, $1,250,000 0.2449 0.34, etc. (MACRS depreciation for a seven-year asset)
*Rounded
b

2.

Old operating system (with adjustment for inflation):

Year
0
1
2
3
4
5
6
7
8
9
10
NPV

Cash Flow*
$
0
(206,240)
(215,850)
(225,844)
(236,237)
(247,047)
(258,289)
(269,981)
(282,140)
(294,786)
(307,937)

Discount Factor
1.000
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322

Present Value**
$
0
(184,172)
(172,032)
(160,801)
(150,247)
(140,076)
(130,953)
(122,031)
(113,985)
(106,418)
(99,156)
$(1,379,871)

*{[(1.04) $350,000 0.66] + [0.34 $100,000]}, n = 1 ... 10

**Rounded

462

1331 Concluded
Flexible system (with adjustment for inflation):
Year
0
1
2
3
4
5
6
7
8
9
10
NPV

Cash Flow*
$(1,250,000)
(4,475)
36,267
3,804
(20,267)
(38,331)
(41,426)
(44,556)
(66,854)
(89,242)
(92,811)

Discount Factor
1.000
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322

Present Value
$(1,250,000)
(3,996)
28,905
2,708
(12,890)
(21,734)
(21,003)
(20,139)
(27,009)
(32,216)
(29,885)
$(1,387,259)

*{[(1.04)n $95,000 0.66] + [Annual depreciation 0.34]}, n = 1 ... 10; depreciation is MACRS.
3.

It is very important to adjust cash flows for inflationary effects. Since the required rate of return for capital budgeting analysis reflects an inflationary
component at the time NPV analysis is performed, a correct analysis also requires that the predicted operating cash flows be adjusted to reflect inflationary effects. If the operating cash flows are not adjusted, then an erroneous
decision may be the outcome. Notice, for example, that after adjusting for inflation, there is virtually no difference between the two systemsand given
the intangibles associated with the flexible system, it would likely be chosen.

463

MANAGERIAL DECISION CASES

1332
The statement that Manny would normally have taken the first bid without hesitation implies that the bid met all of the formal requirements outlined by the company. If Mannys friend had met the bid as requested, then presumably Manny
would have offered the business to his friend. The motive for this was friendship
and possibly carried with it past experience in dealing with Todds company. Perhaps there was some uncertainty in Mannys mind about the low bidders ability
to execute the requirements of the bid, especially since the winning bid was from
out of state. If there was some legitimate concern about the winning bid and Manny was hopeful of eliminating this concern by dealing with a known quantity, then
it could be argued that the call to Todd was justifiable. If, on the other hand, the
only motive was friendship and Manny was confident that the winning bid could
execute (as he appears to have been), then the call was improper. Objectivity and
integrity in carrying out the firms bidding policies are essential.
The fact that Manny was tempted by Todds enticements and appeared to be leaning toward accepting Todds original offer compounds the difficulty of the issue.
If Manny actually accepts Todds offer and grants the business at the original
price and accepts the gifts, then his behavior is unquestionably unethical. Some
of the standards of ethical conduct that would be violated are listed below.
II. Confidentiality
1. Refrain from disclosing confidential information acquired in the course of
their work except when authorized, unless legally obligated to do so.
3. Refrain from using or appearing to use confidential information acquired
in the course of their work for unethical or illegal advantage either personally or through a third party.
III. Integrity
3. Refuse any gift, favor, or hospitality that would influence their actions.

464

1333
1.

Shaftel Ready Mix

Income Statement
For the Year Ended 20XX
Sales (35,000 $45) ..................................................
Less: Variable expenses ($35.08 35,000) .............
Contribution margin .................................................
Less fixed expenses:
Salaries .................................................................
Insurance ..............................................................
Telephone .............................................................
Depreciation .........................................................
Utilities ..................................................................
Net income .................................................................

$ 1,575,000
1,227,800
$ 347,200
$135,000
75,000
5,000
56,200*
25,000
$

296,200
51,000

*Reported depreciation erroneously included $2,000 for the land.

Ratio of net income to sales = $51,000/$1,575,000 = 3.24%
Karl is correct that the return on sales is significantly lower than the company
average.
2.

Payback period = Original investment/Annual cash flow

= $352,000/$107,200*
= 3.28 years
*Net income of $51,000 + depreciation of $56,200
Karl is not right. The book value of the equipment and the furniture should
not be included in the amount of the original investment because there is no
opportunity cost associated with them. Excluding the book value reduces the
investment from $582,000 to $352,000. Karls payback would be correct if the
equipment and furniture could be sold for their book value because there
would now be an opportunity cost associated with them and that cost should
be included in the original investment.

465

1333 Continued
3.

NPV:
Year
0
110
NPV

Cash Flow
$(352,000)
107,200

Discount Factor
1.000
6.145

Present Value
$(352,000)
658,744
$ 306,744

IRR:
df = I/CF
= $352,000/$107,200
= 3.284
Thus, the IRR is between 26 percent and 28 percent.
If the furniture and equipment can be sold for book value:
NPV:
Year
0
110
NPV

Cash Flow
(582,000)
107,200

Discount Factor
1.000
6.145

Present Value
$(582,000)
658,744
$ 76,744

IRR:
df = 582,000/$107,200
= 5.4291
Thus, the IRR is between 12 percent and 14.88 percent.

Using equipment and furniture for the plant INSTEAD of selling it

represents an investment equal to the market value of the assets; the opportunity cost is the key concept here.

466

1333 Continued
4.

Break-even:
$45X = $35.08X + $296,200
$9.92X = $296,200
X = 29,859 cubic yards
NPV (using break-even amount):
Year
0
110
NPV

Cash Flow
$(352,000)
56,200

Discount Factor
1.000
6.145

Present Value
$(352,000)
345,349
$ (6,651)

IRR:
df = $352,000/$56,200
= 6.263
Thus, the IRR is between 8 percent and 10 percent.
The investment is not acceptable, although it came close. It is possible to
have a positive NPV at the break-even point. Break-even is defined for accounting income, not for cash flow. Since there are noncash expenses deducted from revenues, accounting income understates cash income. Zero income does not mean zero cash inflows.

467

1333 Concluded
5.

Cost of capital = 10 percent for 10 years, so df = 6.145

df
6.145
6.145 CF
CF

= I/CF
= $352,000/CF
= $352,000
= $57,282

Cash flow
Less: Depreciation
Net income
Net income
$1,082
$1,082
$297,282
X

$ 57,282
56,200
$ 1,082

= Sales Variable expenses Fixed expenses

= $45X $35.08X $296,200
= $9.92X $296,200
= $9.92X
= 29,968 cubic yards

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net income

$ 1,348,560
1,051,277
$ 297,283
296,200
$
1,083*

*Difference due to rounding

1334
1.

After-tax cash flows

Manual system:
Year
110

(1 t)Ra
$264,000

(1 t)Cb
$(198,000)

tNCc
$6,800

0.66 $400,000
0.66 $228,000 + [0.66 ($92,000 $20,000)]
c
0.34 $20,000
b

468

Cash Flow
$72,800

1334 Continued
Robotic system:
Year
0
1
2
3
4
5
6
7
8
9
10

(1 t)Ra

(1 t)Cb

tNCc

$264,000
297,000
330,000
396,000
396,000
396,000
396,000
396,000
396,000
409,200

$(136,720)
(146,220)
(155,720)
(174,720)
(174,720)
(174,720)
(174,720)
(174,720)
(174,720)
(174,720)

$25,265
43,298
30,922
22,082
15,788
15,771
15,788
7,885

Cash Flow
$(425,600)d
152,545
194,078
205,202
243,362
237,068
237,051
237,068
229,165
221,280
234,480

Year 1: 0.66 $400,000; Year 2: 0.66 $450,000; Year 3: 0.66 $500,000; Years
49: 0.66 $600,000; Year 10: 0.66 $620,000 (includes salvage value as a
gain)

After-tax cash expenses:

Fixed:
Direct labor
Other

$20,000 0.66 = $13,200 (one operator)

$72,000 0.66 = 47,520 (from income statement)
$60,720

Variable:
Direct materials
Variable overhead
Variable selling
Total

(0.16 Sales)
(0.09 Sales)
(0.12 Sales)
0.19

0.75 0.66
0.6667 0.66
0.90 0.66
Sales

Total after-tax cash expenses = $60,720 + (0.19 Sales)

c

Years 18: MACRS: 0.1429 $520,000 0.34, 0.2449 $520,000 0.34, etc.

Net investment:
Purchase costs
Recovery of capital
Tax savings on loss

$(520,000)
40,000
54,400*
$(425,600)

*Year 0: 0.34 ($200,000 $40,000)

469

1334 Continued
2.

Manual system:
Cash Flow
Year
0
$
0
110
72,800
NPV

Discount Factor
1.000
5.650

Present Value
$
0
411,320
$411,320

Discount Factor
1.000
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322

Present Value
$(425,600)
136,223
154,680
146,104
154,778
134,418
120,185
107,155
92,583
79,882
75,503
$ 775,911

Robotics system:
Year
0
1
2
3
4
5
6
7
8
9
10
NPV

Cash Flow
$(425,600)
152,545
194,078
205,202
243,362
237,068
237,051
237,068
229,165
221,280
234,480

The company should invest in the robotic system.

470

1334 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 percent:
Year
0
110
NPV

Cash Flow
$(340,000)
80,000

Discount Factor
1.000
5.650

Present Value
$(340,000)
452,000
$ 112,000

Using a discount rate of 20 percent:

Year
0
110
NPV

Cash Flow
$(340,000)
80,000

Discount Factor
1.000
4.192

Present Value
$(340,000)
335,360
$ (4,640)

If the 20 percent 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
qualityfeatures that would likely cause severe difficulty for the more conservative firm.

RESEARCH ASSIGNMENTS
1335
Answers will vary.

1336
Answers will vary.

471

472