CHAPTER 20

CAPITAL INVESTMENT
QUESTIONS FOR WRITING AND DISCUSSION
1. Independent projects are such that the
acceptance of one does not preclude the
acceptance of another. With mutually
exclusive projects, however, acceptance of
one precludes the acceptance of others.

and managers are accustomed to working

with rates of return.

2. The timing and quantity of cash flows

determine the present value of a project.
The present value is critical for assessing
whether or not a project is acceptable.
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. It is used for
three reasons: (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.

10.

NPV analysis is only as good as the

accuracy of the cash flows. If cash flows are
not accurate, then incorrect investment
decisions can be made.

11.

Gains and losses on the sale of existing

assets should be considered.

12.

MACRS provides higher depreciation (a

noncash expense) in earlier years than
straight-line does. Depreciation expense
provides a cash inflow from the tax savings
it produces. As a consequence, the present
value of the shielding benefit is greater for
MACRS.

13.

Intangible and indirect benefits are

important factorsmore important in the
avanced
manufacturing
and
P2
environments.
Greater
quality,
more
reliability, reduced lead times, 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.

14.

A postaudit is a follow-up analysis of an

investment decision. It compares the
projected costs and benefits with the actual
costs and benefits. It is especially valuable
for advanced technology investments since
it reveals intangible and indirect benefits
that can be considered in similar
investments in the future.

15.

Sensitivity analysis involves changing

assumptions to see how the changes affect
the original outcome. In capital investment
decisions, sensitivity analysis can be used
to help assess the risk of a project.
Uncertainty in forecasted cash flows can be
dealt with by altering projections to see how
sensitive the decision is to errors in
estimates.

5. The accounting rate of return is the average

income divided by investment.
6. 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. In capital budgeting, the cost of
capital is the rate used to discount future
cash flows.
7. 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.
8.

If NPV 0, then the investment is

acceptable. If NPV < 0, then the investment
should be rejected.

9.

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,

196

EXERCISES
201
1.

Payback period = $62,500/$15,625 = 4.00 years

2.

ARR = ($180,000 $60,000)/$600,000

= 20%

3.

Payback period:
Year 1....................
Year 2....................
Year 3....................
Year 4....................
Year 5....................

Cash Flow
$ 87,500
122,500
175,000
175,000
175,000*

Unrecovered Investment
$612,500
490,000
315,000
140,000

*Only $140,000 is needed to finish recovery; thus, payback is 4.8 years.

Average cash flows = $1,610,000/10 = $161,000 (total cash flows = $87,500 +
$122,500 + (8 $175,000) = $1,610,000)
Average investment = $700,000/2 = $350,000
Annual depreciation = $700,000/10 = $70,000
ARR = ($161,000 $70,000)/$350,000 = 26%

202
1.

F = $5,000(1.03)2 = $5,304.50

2.

4%: P = $50,000 0.790 = $39,500

6%: P = $50,000 0.705 = $35,250
8%: P = $50,000 0.636 = $31,800

3.

CF(df) = $500,000 (where CF = Annual cash flow; df = Discount factor)

CF(4.623) = $500,000
CF = $500,000/4.623
= $108,155

196

203
1.

NPV = P I
= (5.335 $1,000,000) $6,000,000
= ($665,000)
The system should not be purchased.

2.

df = Investment/Annual cash flow

= $1,350,000/$217,350 = 6.211
IRR = 6%
The decision is good. The outcome covers the cost of capital.

204
1.

Payback period = Original investment/Annual cash inflow

= $2,340,000/($3,042,000 $2,340,000)
= $2,340,000/$702,000
= 3.33 years

2.

a. Initial investment (Depreciation = $468,000):

Accounting rate of return = Average income/Investment
= ($702,000 $468,000)/$2,340,000
= 10%
b. Average investment:
Accounting rate of return = ($702,000 $468,000)/[($2,340,000 + $0)/2]
= $234,000/$1,170,000
= 20%

3.

4.

Year
Cash Flow
Discount Factor
0.................. $(2,340,000)
1.000
15................
702,000
3.791
NPV..............................................................................................

Present Value
$(2,340,000)
2,661,282
$ 321,282

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

df = Investment/Annual cash flow
= $2,340,000/$702,000
= 3.333
For five years and a df of 3.333, the IRR is between 14% and 16%
(approximately 15.3%).

197

205
X-ray equipment:
Year
Cash Flow
Discount Factor
0................ $(750,000)
1.000
1................
375,000
0.893
2................
150,000
0.797
3................
300,000
0.712
4................
150,000
0.636
5................
75,000
0.567
NPV.............................................................................................

Present Value
$(750,000)
334,875
119,550
213,600
95,400
42,525
$ 55,950

Biopsy equipment:
Year
Cash Flow
Discount Factor
0................ $(750,000)
1.000
1................
75,000
0.893
2................
75,000
0.797
3................
525,000
0.712
4................
600,000
0.636
5................
675,000
0.567
NPV.............................................................................................

Present Value
$(750,000)
66,975
59,775
373,800
381,600
382,725
$ 514,875

206
1.

X-ray equipment:
Payback period = $375,000
150,000
225,000
$ 750,000

1.00 year
1.00
0.75 ($225,000/$300,000)
2.75 years

Biopsy equipment:
Payback period = $ 75,000
75,000
525,000
75,000
$ 750,000

1.00 year
1.00
1.00
0.13 ($75,000/$600,000)
3.13 years

This might be a reasonable strategy because payback is a rough measure of

risk. The assumption is that the longer it takes a project to pay for itself, the
riskier the project is. Other reasons might be that the firm might have liquidity
problems, the cash flows might be risky, or there might be a high risk of
obsolescence.

198

206
2.

Concluded

X-ray equipment:
Average cash flow = ($375,000 + $150,000 + $300,000 + $150,000 + $75,000)/5
= $210,000
Average depreciation = $750,000/5
= $150,000
Average income = $210,000 $150,000
= $60,000
Average investment = $750,000/2
= $375,000
Accounting rate of return = $60,000/$375,000
= 16%
Biopsy equipment:
Average cash flow = ($75,000 + $75,000 + $525,000 + $600,000 + $675,000)/5
= $390,000
Average investment = $750,000/2
= $375,000
Accounting rate of return = ($390,000 $150,000*)/$375,000
= 64%
*Average depreciation.

207
1.

a. Return of the original investment.............................................. $370,000

b. Cost of capital ($370,000 12%)................................................ 44,400
c. Profit earned on the investment ($450,000 $414,400)........... 35,600
Present value of profit:
P = Future profit Discount factor
= $35,600 0.893
= $31,791

2.

Year
Cash Flow
Discount Factor
Present Value
0............... $(370,000)
1.000
$(370,000)
1...............
450,000
0.893
401,850
NPV..............................................................................................
$ 31,850
Net present value gives the present value of future profits. (The slight
difference is due to rounding in the discount factor.)

199

208
1.

P =I
= df CF
2.914* CF = $120,000
CF = $41,181
*From Exhibit 20B-2, 14% for four years.

2.

For IRR: (Discount factors from Exhibit 20B-2)

I = df CF
I = 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 20B-2, 18% column, the year corresponding to df = 5.008 is 14.
Thus, the lathe must last for 14 years.

200

208
4.

Concluded

X = Cash flow in Year 4

Investment = 3X
Year
Cash Flow
Discount Factor
0..................
(3X)
1.000
1..................
15,000
0.909
2..................
20,000
0.826
3..................
30,000
0.751
4..................
X
0.683
NPV..............................................................................................
3X + $13,635 + $16,520 + $22,530 + 0.683X
2.317X + $52,685
2.317X
X

= $6,075
= $6,075
= $46,610
= $20,117

Cash flow in Year 4 = X = $20,117

Cost of project = 3X = $60,351

209
1.

Payback period = Investment/Annual cash flow

= $9,000,000/$1,500,000
= 6.00 years
The system would not be acquired.

2.

NPV = P I
= (5.650 $1,500,000) $9,000,000
= ($525,000)
df = $9,000,000/$1,500,000 = 6.00
IRR is between 10% and 12% (IRR = 10.6%).
NPV and IRR also signal rejection of the project.

201

Present Value
$
(3X)
13,635
16,520
22,530
0.683X
$ 6,075

209
3.

Concluded

Payback period = $9,000,000/$1,800,000 = 5.00 years

NPV:
Year
Cash Flow
Discount Factor
0.................. $(9,000,000)
1.000
110..............
1,800,000
5.650
10.................
1,000,000
0.322
NPV..............................................................................................

Present Value
$ (9,000,000)
10,170,000
322,000
$ 1,492,000

IRR: df = 5.000 = $9,000,000/$1,800,000

IRR (without salvage value) is now between 14% and 16% (approximately
15.13%).
Payback, NPV, and IRR all now signal acceptance.
The decrease in salvage value does not change the decision for any of the
three measures. NPV decreases by $161,000 (0.322 $500,000). For this
company, including salvage value is not critical. The increased cash inflow
for the expanded market share drives the change in decision. The presence
of salvage value, however, increases the attractiveness of the investment and
reduces the uncertainty about the outcome.

2010
1.

NPV System I:
Year
Cash Flow
Discount Factor
0.................... $(120,000)
1.000
1....................

2....................
162,708
0.826
NPV.................................................................................................

Present Value
$(120,000)

134,397
$ 14,397

NPV System II:

Year
Cash Flow
Discount Factor
0.................... $(120,000)
1.000
12..................
76,628
1.736
NPV.................................................................................................
System I should be chosen using NPV.

202

Present Value
$(120,000)
133,026
$ 13,026

2010 Concluded
IRR System I:
I = df CF
$120,000 = $162,708/(1 + i)2
(1 + i)2 = $162,708/$120,000
= 1.3559
1 + i = 1.1645
IRR = 16.5%
IRR System II:
df = I/CF
= $120,000/$76,628
= 1.566
From Exhibit 20B-2, IRR = 18%
System II should be chosen using IRR.
2.

Modified comparison:
Year
System I
0.................... $(120,000)
1....................

2....................
162,708
*($76,628 1.10) + $76,628

System II
$(120,000)

160,919*

Notice that the future value of System I is greater than that of System II and
thus maximizes the value of the firm. NPV signals the correct choice, whereas
IRR would have chosen System II.

2011
Project I:
CF = NI + Noncash expenses
= $18,000 + $15,000
= $33,000
Project II:
CF = (1 t) (Cash expenses) + (t Noncash expenses)
= 0.6 ($30,000) + (0.4 $30,000)
= $18,000 + $12,000
= ($6,000)

2012
203

1.

Year
Depreciation
1...........
$3,000
2...........
6,000
3...........
6,000
4...........
3,000

tNC
$1,200
2,400
2,400
1,200

df
0.893
0.797
0.712
0.636

Present Value
$1,072
1,913
1,709
763
$ 5,457

2.

Year
Depreciation
1...........
$6,000
2...........
8,000
3...........
2,666
4...........
1,334

tNC
$2,400
3,200
1,066
534

df
0.893
0.797
0.712
0.636

Present Value
$2,143
2,550
759
340
$ 5,792

3.

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

204

2013
1.

$10,000 $25,000 = $(15,000) loss

0.40 tax rate
$ 6,000 tax savings
Sales price.............
Tax savings............
Net proceeds....

$10,000
6,000
$16,000

Total cost of new press....................... $50,000

Less: net proceeds of old press........ (16,000)
Net investment (cash outflow)...... $34,000
2.

3.

Year
1...............
2...............
3...............
4...............

(1 t)Ca
$(1,200)
(1,200)
(1,200)
(1,200)

(1 0.40) $2,000.

(0.40)($30,000)(0.2000).
(0.40)($30,000)(0.3200).
(0.40)($30,000)(0.1920).
(0.40)($30,000)(0.1152).

tNCb
2,400
3,840
2,304
1,382

CF
$1,200
2,640
1,104
182

a. After-tax cash flow (CF):

CF = $50,000
= $30,000 (NI) + $20,000 (depreciation)
b. After-tax cash flow from revenues = $72,000 = [(1 0.4)$120,000]
c. After-tax cash expenses = $30,000 = [(1 0.4)$50,000]
d. Cash inflow tax effect of depreciation = $8,000 = (0.4 $20,000)

205

PROBLEMS
2014
1.

2.

Year 0......................................................................................$

(420,000)

Year 1:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Depreciation shield [0.40 ($420,000/7) 0.5]...............
Total................................................................................

$ (21,000)
145,800
12,000
$ 136,800

Years 27:
Operating costs..................................................................
Savings................................................................................
Depreciation shield (0.40 $60,000)................................
Total................................................................................

$ (21,000)
145,800
24,000
$ 148,800

Year 8:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Depreciation shield (0.40 $30,000)...............................
Total................................................................................

$ (21,000)
145,800
12,000
$ 136,800

Years 910:
Operating costs (0.60 $35,000)......................................
Savings (0.60 $243,000)..................................................
Total................................................................................

$ (21,000)
145,800
$ 124,800

Payback period:
$136,800
148,800
134,400
$ 420,000

3.

1.00 year
1.00
0.90
($134,400/$148,800)
2.90 years

Year
Cash Flow
Discount Factor
0................... $(420,000)
1.000
1...................
136,800
0.862
27.................
148,800
3.176
8...................
136,800
0.305
9...................
124,800
0.263
10..................
124,800
0.227
NPV.........................................................................................

Present Value
$(420,000)
117,922
472,589
41,724
32,822
28,330
$ 273,387

The NPV is positive and signals the acceptance of the project.

206

2014 Concluded
4.

Most of the factors mentioned can be quantified. Furthermore, they should be

included in the analysis. All direct and indirect costs as well as costs of
intangible factors should be included; otherwise, it is possible to miss out on
a very profitable investment. The exclusion of the environmental fine is
especially puzzling it is easily quantified, and certainly its avoidance is an
important savings. The effect on sales may also be estimated there is
already some indication that the company is assessing this outcome.
Similarly, it should not be especially hard to get some handle on the potential
litigation costs. There should be ample cases.
Annual cash flows increase by $90,000 (fines and sales effect) [e.g., cash
inflows increase to $226,800 in Year 1 ($136,800 + $90,000) and $238,800 for
Years 27 ($148,800 + $90,000)].
Payback:
$226,800
193,200
$ 420,000

1.00 year
0.81
($193,200/$238,800)
1.81 years

The payback is reduced by 1.09 years.

NPV is increased by the following amount:
Fines and sales effect ($90,000 4.833)....
Lawsuit avoidance ($200,000 0.641)........
Total increase in NPV.............................

$434,970
128,200
$563,170

The effect of the omitted factors is greater than the included factors. While
this may not be the normal state, it emphasizes the importance of including
all related factors in the analysis. As mentioned, their exclusion may cause a
company to pass up a profitable investment opportunity.

2015
1.

Traditional equipment (18% rate):

Year
Cash Flow
df
0.................. $(1,000,000)
1.000
1..................
600,000
0.847
2..................
400,000
0.718
310...............
200,000
2.928
NPV......................................................................................

207

Present Value
$(1,000,000)
508,200
287,200
585,600
$ 381,000

2015

Continued

Contemporary technology:
Year
Cash Flow
df
0.................. $(4,000,000)
1.000
1..................
200,000
0.847
2..................
400,000
0.718
3..................
600,000
0.609
46................
800,000
1.323
7..................
1,000,000
0.314
810...............
2,000,000
0.682
NPV......................................................................................
2.

Present Value
$(4,000,000)
169,400
287,200
365,400
1,058,400
314,000
1,364,000
$ (441,600)

Traditional equipment (14% rate):

Year
Cash Flow
df
0.................. $(1,000,000)
1.000
1..................
600,000
0.877
2..................
400,000
0.769
310...............
200,000
3.571
NPV......................................................................................

Present Value
$(1,000,000)
526,200
307,600
714,200
$ 548,000

Contemporary technology:
Year
Cash Flow
df
0.................. $(4,000,000)
1.000
1..................
200,000
0.877
2..................
400,000
0.769
3..................
600,000
0.675
46................
800,000
1.567
7..................
1,000,000
0.400
810...............
2,000,000
0.929
NPV......................................................................................
3.

Present Value
$(4,000,000)
175,400
307,600
405,000
1,253,600
400,000
1,858,000
$ 399,600

The cost of capital is the rate that should be usedit usually reflects the
opportunity cost of the funds needed to make the investment. A higher rate
will bias against the acceptance of contemporary technologywhich usually
has large initial outlays and larger returns later in the life of the project.
Notice how the use of the 14% rate moved the NPV of the contemporary
technology alternative from a negative to a positive value. Its enough of a
movement that qualitative factors could now lead to the contemporary
technology alternative being selected even though the other alternative still
has a larger NPV.

208

2015 Concluded
4.

Traditional equipment:
Year
Cash Flow
df
0.................. $(1,000,000)
1.000
1..................
600,000
0.877
2..................
400,000
0.769
310...............
100,000
3.571
NPV......................................................................................

Present Value
$(1,000,000)
526,200
307,600
357,100
$ 190,900

The decision reverses; the contemporary technology system is now

preferred. To remain competitive, managers must make good decisions, and
this exercise emphasizes how indirect benefits can affect decisions.
Intangibles such as customer satisfaction and on-time deliveries are
important and can be translated into quantitative effects.

2016
1.

Proposal A:
Year
Cash Flow
Discount Factor
0................... $(100,000)
1.000
1...................
150,000
0.909
2...................
125,000
0.826
3...................
75,000
0.751
4...................
37,500
0.683
5...................
25,000
0.621
6...................
12,500
0.564
NPV.........................................................................................

Present Value
$(250,000)
136,350
103,250
56,325
25,613
15,525
7,050
$ 94,113

Proposal B:
Year
Cash Flow
Discount Factor
0................... $(312,500)
1.000
1...................
(37,500)
0.909
2...................
(25,000)
0.826
3...................
(12,500)
0.751
4...................
212,500
0.683
5...................
275,000
0.621
6...................
337,500
0.564
NPV.........................................................................................

2016 Concluded
209

Present Value
$(312,500)
(34,088)
(20,650)
(9,388)
145,138
170,775
190,350
$ 129,637

2.

Proposal A payback period:

First year...............................................
Second year ($100,000/$125,000).......

1.00 year
0.80
1.80 years

$150,000
200,000
$ 350,000

1.00 year
1.00
1.00
1.00
0.64
4.64 years

$ (37,500)
(25,000)
(12,500)
212,500
175,000
$ 312,500

Proposal B payback period:

First year...............................................
Second year..........................................
Third year..............................................
Fourth year............................................
Fifth year ($175,000/$275,000)............
3.

Based on the NPV analysis, both proposals could be accepted as they have
positive NPVs. Proposal B, in fact, has the higher NPV.

4.

Kent may have accepted only Proposal A because of the fact that his
performance is going to be closely monitored over the next three years.
Proposal B had negative cash flows projected for the first three years. This
would hurt his divisional profits during that time, and he may feel that this
would hurt his chances for promotion to higher management. It is also
possible that he was concerned about the effect the proposal would have on
his bonus payments.
Kent might have rejected Proposal B because of the longer payback period.
He may have felt that this increased the risk associated with the project to an
unacceptable level. It might also be possible that the firm has liquidity
problems and needs projects with quick paybacks. The latter, however, is not
likely given the fact that his division has had high performance ratings over
the past three years.
If Kents reasons for rejecting the proposal were based on his concerns about
his promotion and bonuses rather than legitimate economic reasons, then his
behavior is unethical. To consciously subvert the legitimate objectives of an
organization for the pursuit of personal goals is not right. It might also be
noted that perhaps the organization needs to reduce its emphasis on shortterm profit performance.

210

2017
1.

df = Investment/Annual cash flow

= $750,000/$150,000
= 5.0
The IRR is between 14% and 16% (approximately 15.13%).
The company should acquire the new IT system since the cost of capital is
only 12%.

2.

Since I = P for the IRR, the minimum cash flow is:

I = df CF
$750,000 = 5.650* CF
5.650 CF = $750,000
CF = $132,743
*From Exhibit 20B-2, discount factor at 12% (cost of capital) for 10 years.
The safety margin is $17,257 ($150,000 $132,743). This seems to suggest
that there is not much room for erroras the savings are all tied to labor.

3.

For a life of eight years:

df = I/CF
= $750,000/$150,000
= 5.0
The IRR is between 10% and 12% (approximately 11.83%).
The system is about at the break-even point (point of indifference).
Minimum cash flow at 12% for eight years:
I = df CF
$750,000 = 4.968 CF
4.968 CF = $750,000
CF = $150,966
The less sensitive the decision is to changes in estimates, the safer the
decision. In this case, a 2-year difference in project life moves the investment
into a marginal zone. Thus, the company may wish to examine carefully its
assumptions concerning project life.

211

2018
Keep old MRI equipment:
Year
(1 t)Ra (1 t)Cb
tNCc
CF
df
1.......

$(600,000)
$320,000
$(280,000)
0.893
2.......

(600,000)
320,000
(280,000)
0.797
3.......

(600,000)
160,000
(440,000)
0.712
4.......

(600,000)

(600,000)
0.636
5....... $(60,000)
(600,000)

(540,000)
0.567
NVP...................................................................................................................
....................................................................................................... (1,474,260)
a

0.60 $100,000.

b
c

Present Value
$ (250,040)
(223,160)
(313,280)
(381,600)
(306,180)
$

(0.60) $1,000,000.

Years 1 and 2: 0.40 $800,000; Year 3: 0.40 $400,000. The class life has two
years remaining; thus, there are three years of depreciation to claim, with the
last year being only half. Let X = Annual depreciation. Then X + X + X/2 =
$2,000,000 and X = $800,000.

Buy new MRI equipment:

Yr. (1 t)Ra (1 t)Cb
tNCc
Otherd
CF
df
Pres. Value
0....
$600,000 $(4,500,000) $(3,900,000) 1.000 $(3,900,000)
1....
$(300,000) 400,000

100,000
0.893
89,300
2....
(300,000) 640,000

340,000
0.797
270,980
3....
(300,000) 384,000

84,000
0.712
59,808
4....
(300,000) 230,400

(69,600) 0.636
(44,266)
5.... $427,200 (300,000) 230,400
288,000
645,600
0.567
366,055
NPV................................................................................................................ $(3,158,123)
a

0.60 ($1,000,000 Book value), where Book value = $5,000,000 $4,712,000.

b
c

(0.60) $500,000.

Year 0: Tax savings from loss on sale of asset: 0.40 $1,500,000 (The loss on the
sale of the old computer is $2,000,000 $500,000.)
Years 15: Tax savings from MACRS depreciation: $5,000,000 0.20 0.40;
$5,000,000 0.32 0.40; $5,000,000 0.192 0.40; $5,000,000 0.1152 0.40;
$5,000,000 0.1152 0.40.
Note: The asset is disposed of at the end of the fifth yearthe end of its class
lifeso the asset is held for its entire class life, and the full amount of
depreciation can be claimed in Year 5.

Purchase cost ($5,000,000) less proceeds from sale of old computer ($500,000);
recovery of capital from sale of machine at the end of Year 5 is simply the book
value of $288,000 (original cost less accumulated depreciation).

212

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

2019
1.

Old system (dollars in thousands):

Year
(1 t)R
(1 t)C
tNC
Cash Flow
df
Present Value
0.....
$
0
1.000
$
0
19. . . $18,000
$(13,440)
$240
4,800
4.031
19,349
10....
18,000
(13,440)

4,560
0.162
739
NPV.....................................................................................................
$ 20,088
New system (dollars in thousands):
Year (1 t)R (1 t)Ca
tNCb
Otherc Cash Flow
df
Present Value
0.....
$ 960 $(51,000) $(50,040) 1.000
$(50,040)
110. . $18,000 $(7,740)
2,160

12,420 4.192
52,065
NPV....................................................................................................... $ 2,025
a

Direct materials (0.75 $80)...... $ 60

Direct labor (0.4 $90)...............
36
Volume-related OH ($20 $4)....
16
Direct FOH ($34 $17)...............
17
Unit cost..................................
$129
Total cash expenses = $129 100,000 = $12,900,000
After-tax cash expenses = 0.6 $12,900,000 = $7,740,000

Year 0: Tax savings on loss from sale of old machine = 0.4 $2,400,000 =
$960,000;
Years 110: Depreciation = 0.4 $54,000,000/10 = $2,160,000.

Net outlay = $54,000,000 $3,000,000 = $51,000,000.

The old system should be chosen because it has the higher NPV.
2.

Old system (dollars in thousands):

Year
(1 t)R
(1 t)C
tNC
CF
df
0.......
$
0
1.000
19...... $18,000
$(13,440)
$240
4,800
5.328
10...... 18,000
(13,440)

4,560
0.322
NPV....................................................................................................

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

New system (dollars in thousands):

Year (1 t)R (1 t)C
0.....
110. . $18,000 $(7,740)

tNC
Other
CF
df
Present Value
$ 960 $(51,000) $(50,040) 1.000
$(50,040)
2,160

12,420 5.650
70,173
213

NPV.....................................................................................................

$ 20,133

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

214

2019 Concluded
3.

Old system with declining sales (dollars in thousands):

Year
(1 t)R
(1 t)C*
tNC
CF
df
Present Value
0.......
$
0
1.000
$
0
1....... $18,000
$(13,440)
$240
4,800
0.893
4,286
2....... 16,200
(12,300)
240
4,140
0.797
3,300
3....... 14,400
(11,160)
240
3,480
0.712
2,478
4....... 12,600
(10,020)
240
2,820
0.636
1,794
5....... 10,800
(8,880)
240
2,160
0.567
1,225
6.......
9,000
(7,740)
240
1,500
0.507
761
7.......
7,200
(6,600)
240
840
0.452
380
8.......
5,400
(5,460)
240
180
0.404
73
9.......
3,600
(4,320)
240
(480)
0.361
(173)
10......
1,800
(3,180)

(1,380)
0.322
(444)
NPV.....................................................................................................
$ 13,680
*Cash expenses = Fixed + Variable
= $3,400,000 (Direct fixed) + $190X
X = Units sold
After-tax cash expense = $2,040,000 + $114X (0.6 above formula)

4.

For the new system, salvage value would increase after-tax cash flows in Year
10 by $2,400,000 (0.6 $4,000,000). Using the discount factor of 0.322, the
NPV of the new system will increase from $20,133,000 to $20,905,800 (an
increase of 0.322 $2,400,000), making the new investment more attractive.
The NPV analysis for the old system remains unchanged.

5.

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

The rate of 20% 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 as fast or at the same level of quality as the
new system, factors that could 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.

215

2020
1.

Schedule of cash flows:

Year
2009

Item
Equipment
Discount
Freight
Installation
Salvageold (0.6 $1,500)
Working capital reduction

CF
$(945,000)
18,900
(11,000)
(22,900)
900
2,500

2010

Operating expensesa
Depreciation tax shieldb

$(627,000)
127,987

2011

Operating expenses
Depreciation tax shieldb

$(627,000)
170,688

2012

Operating expensesa
Depreciation tax shieldb

$(651,000)
56,870

2013

Operating expenses
Depreciation tax shieldb

$(687,000)
28,454

2014

Operating expensesa
Salvagenew (0.6 $12,000)

$(687,000)
7,200

$(956,600)
(499,013)
a

(456,312)
(594,130)
a

(658,546)

(679,800)
a

Unit cost:
DM......... $10 0.75
DL .........
8 1.00
VOH.......
6 0.75
Total..........................

Depreciation shield:
Year
Value
2010
$960,000
2011
960,000
2012
960,000
2013
960,000

$ 7.50
8.00
4.50
$ 20.00
Rate
0.3333
0.4445
0.1481
0.0741

Allowance
$319,968
426,720
142,176
71,136

216

Tax Rate
0.40
0.40
0.40
0.40

Shield
$127,987
170,688
56,870
28,454

2020 Continued
Year
2010

Variable costs:
Fixed costs:

$20 50,000 = $1,000,000 0.6 = $600,000

$45,000 0.6 = $27,000

2010

Variable costs:
Fixed costs:

$20 50,000 = $1,000,000 0.6 = $600,000

$45,000 0.6 = $27,000

2012

Variable costs:
Fixed costs:

$20 52,000 = $1,040,000 0.6 = $624,000

$45,000 0.6 = $27,000

2013

Variable costs:
Fixed costs:

$20 55,000 = $1,100,000 0.6 = $660,000

$45,000 0.6 = $27,000

2014

Variable costs:
Fixed costs:

$20 55,000 = $1,100,000 0.6 = $660,000

$45,000 0.6 = $27,000

NPV:
Year
CF
df
2009................. $(956,600)
1.000
2010.................
(499,013)
0.893
2011..................
(456,312)
0.797
2012.................
(594,130)
0.712
2013.................
(658,546)
0.636
2014.................
(679,800)
0.567
NPV........................................................................................
2.

Present Value
$ (956,600)
(445,619)
(363,681)
(423,021)
(418,835)
(385,447)
$(2,993,203)

Schedule of cash flows:

Year
2009
2010
2011
2012
2013
2014

Item
Salvageold
Purchase cost:
Purchase cost:
Purchase cost:
Purchase cost:
Purchase cost:

(0.6 $1,500)
$27 50,000 0.6
$27 50,000 0.6
$27 52,000 0.6
$27 55,000 0.6
$27 55,000 0.6

=
=
=
=
=
=

CF
$
900
(810,000)
(810,000)
(842,400)
(891,000)
(891,000)

NPV:
Year
CF
df
Present Value
2009............
$
900
1.000
$
900
2010............
(810,000)
0.893
(723,330)
2011............
(810,000)
0.797
(645,570)
2012............
(842,400)
0.712
(599,789)
2013............
(891,000)
0.636
(566,676)
2014............
(891,000)
0.567
(505,197)
NPV...................................................................... $(3,039,662)
217

2020 Concluded
3.

The analysis favors internal production because it has a lower cost than
purchasing. Qualitative factors: reliability of supplier, quality of the product,
stability of purchasing price, labor relations, community relations, etc.

2021
1.

Scrubbers and treatment facility (expressed in thousands):

Year (1 t)Ra
(1 t)Cb
tNCc
CF
df
0....
$(50,000)
1.000
1.... $6,000
$(14,400)
$4,000
(4,400)
0.909
2.... 6,000
(14,400)
6,400
(2,000)
0.826
3.... 6,000
(14,400)
3,840
(4,560)
0.751
4.... 6,000
(14,400)
2,304
(6,096)
0.683
5.... 6,000
(14,400)
2,304
(6,096)
0.621
6.... 7,200d
(14,400)
1,152
(6,048)
0.564
NPV....................................................................................................
a

0.6 $10,000,000.

b
c

Present Value
$(50,000)
(4,000)
(1,652)
(3,425)
(4,164)
(3,786)
(3,411)
$(70,438)

0.6 $24,000,000.

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.

Includes salvage value (0.6 $2,000,000).

218

2021 Concluded
Process redesign (expressed in thousands):
Year
(1 t)Ra
(1 t)Cb
tNCc
CF
df
0.....
$(100,000)
1.000
1..... $18,000
$(6,000) $ 8,000
20,000
0.909
2..... 18,000
(6,000) 12,800
24,800
0.826
3..... 18,000
(6,000)
7,680
19,680
0.751
4..... 18,000
(6,000)
4,608
16,608
0.683
5..... 18,000
(6,000)
4,608
16,608
0.621
6..... 19,800d
(6,000)
2,304
16,104
0.564
NPV....................................................................................................
a

0.6 $30,000,000.

b
c

Present Value
$(100,000)
18,180
20,485
14,780
11,344
10,314
9,083
$ (15,814)

0.6 $10,000,000.

Year 1: 0.4 0.2 $100,000,000; Year 2: 0.4 0.32 $100,000,000;

Year 3: 0.4 0.192 $100,000,000;
Years 4 and 5: 0.4 0.1152 $100,000,000;
Year 6: 0.4 0.0576 $100,000,000.

Includes salvage value (0.6 $3,000,000).

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

2.

The modification will add to the cost of the scrubbers and treatment facility
(present value is 0.751 $8,000,000 = $6.008 million). Cleaning up the lake
can be viewed as a cost of the first alternative or a benefit of the second. The
present value of the cleanup cost gives an additional cost (benefit) between
$30.04 and $45.06 million to the first (second) alternative (0.751
$40,000,000) and (0.751 $60,000,000). Adding in the benefit of avoiding the
cleanup cost makes the process redesign alternative profitable (yielding a
positive NPV). Ecoefficiency basically argues that productive efficiency
increases as environmental performance increases and that it is cheaper to
prevent environmental contamination than it is to clean it up once created.
The first alternative is a cleanup approach, while the second is a
prevention approach.

219

2022
1.

After-tax cash flows:

Manual system:
Year
110.........
a

(1 t)Cb
$(180,000)

tNCc
$8,000

Cash Flows
$68,000

0.60 $400,000 (sales).

b
c

(1 t)Ra
$240,000

0.60 $228,000 + [0.60 ($92,000 $20,000)].

0.40 $20,000.

Robotic system:
Year
(1 t)Ra
0.....
1..... $240,000
2..... 270,000
3..... 300,000
4..... 360,000
5..... 360,000
6..... 360,000
7..... 360,000
8..... 360,000
9..... 360,000
10.... 372,000
a

(1 t)Cb
$(124,320)
(132,960)
(141,600)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)
(158,880)

tNCc
$64,000
29,723
50,939
36,379
25,979
18,574
18,554
18,574
9,277

Otherd
$(480,000)

Cash Flows
$(416,000)
145,403
187,979
194,779
227,099
219,694
219,674
219,694
210,397
201,120
213,120

Year 1: 0.60 $400,000; Year 2: 0.60 $450,000; Year 3: 0.60 $500,000;

Years 49: 0.60 $600,000; Year 10: 0.60 $620,000 (includes salvage value
as a gain).

After-tax cash expenses:

Fixed:
Direct labor. . . $20,000 0.60 = $ 12,000 (one operator)
Other.............. $72,000 0.60 = 43,200 (from income statement)
$ 55,200

220

2022 Continued
Variable:
Direct materials........ (0.16 Sales) 0.75 0.60
Variable overhead.... (0.09 Sales) 0.6667 0.60
Variable selling........ (0.12 Sales) 0.90 0.60
Total......................................................................

=
=
=
=

0.0720 Sales
0.0360 Sales
0.0648 Sales
0.1728 Sales

Total after-tax cash expenses = $55,200 + (0.1728 Sales)

c

Year 0: 0.40 ($200,000 $40,000); Years 18: MACRS: 0.1429 $520,000

0.40, 0.2449 $520,000 0.40, etc.: Tax savings on loss ($64,000) [($200,000
$40,000) 0.40].

2.

Net investment:
Purchase costs............. $520,000
Recovery of capital...... (40,000)
Tax savings on loss..... (64,000)
$ 416,000

Manual system:
Year
Cash Flow
Discount Factor
Present Value
0......................
$
0
1.000
$
0
110..................
68,000
5.650
384,200
NPV.............................................................................................
$ 384,200
Robotic system:
Year
Cash Flow
Discount Factor
Present Value
0...................... $(416,000)
1.000
$ (416,000)
1......................
145,403
0.893
129,845
2......................
187,979
0.797
149,819
3......................
194,779
0.712
138,683
4......................
227,099
0.636
144,435
5......................
219,694
0.567
124,566
6......................
219,674
0.507
111,375
7......................
219,694
0.452
99,302
8......................
210,397
0.404
85,000
9......................
201,120
0.361
72,604
10.....................
213,120
0.322
68,625
NPV.............................................................................................
$ 708,254
The company should invest in the robotic system.

221

2022 Concluded
3.

Managers may use a higher discount rate as a way to deal with the
uncertainty in future cash flows. The higher rate protects the manager from
unpleasant surprises. Since a higher rate favors investments that provide
returns quickly, managers may be motivated by personal short-run
considerations, e.g., bonuses and promotion opportunities.
Using a discount rate of 12%:
Year
Cash Flow
Discount Factor
Present Value
0.................... $(340,000)
1.000
$(340,000)
110.................
80,000
5.650
452,000
NPV.............................................................................................
$ 112,000
Using a discount rate of 20%:
Year
Cash Flow
Discount Factor
Present Value
0.................... $(340,000)
1.000
$(340,000)
110.................
80,000
4.192
335,360
NPV.............................................................................................
$ (4,640)
If the 20% discount rate is used, the company would not acquire the robotic
system.
Using an excessive discount rate could seriously impair the ability of the firm
to stay competitive. An excessive discount rate may lead a firm to reject new
technology that would increase quality and productivity. As other firms invest
in the new technology, their products will be priced lower and be of higher
quality, features which would likely cause severe difficulty for the more
conservative firm.

222

COLLABORATIVE LEARNING EXERCISE

2023
1.

Peters suggestion is unethical. The guidelines for capital projects are in

place to help ensure sound decisions. Falsifying data to bypass the
guidelines shows a lack of integrity.

2.

Laura should not comply with Peters request; she should attempt to
convince Peter that a different approach is better. For example, she might
advise him to talk with those who prepared the report. Perhaps he could
convince them that they overlooked some significant factors in favor of the
project. At the very least, this approach would enable Peter to again review
the findings, with the hope that either he or the consultants will alter their
views.

3.

If Laura complies with Peters request, some of the standards that would be
violated are as follows:

4.

I-3.

Provide decision support information and recommendations that are

accurate, clear, concise, and timely.

III-7.

Abstain from engaging in or supporting any activity that might

discredit the profession.

IV-1.

Communicate information fairly and objectively.

IV-2.

Disclose all relevant information that could reasonably be expected

to influence an intended users understanding of the reports,
analyses, or recommendations.

This response increases the difficulty of the situation because it tends to

legitimatize Peters behavior. Nonetheless, a superiors willingness to
condone the behavior does not make it right. Nor does it change the fact that
if Laura complies with the request, she will be violating several ethical
standards. Laura should continue to pursue the matter with higher-level
managers, assuming she is convinced that Peter will insist that the report be
falsified.

CYBER RESEARCH CASE

2024
Answers will vary.

223