Chapter 12

Capital Budgeting Decisions

Solutions to Questions

12-1 Capital budgeting screening decisions 12-8 The cost of capital is often used as the
concern whether a proposed investment project hurdle that must be cleared before an
passes a preset hurdle, such as a positive net investment project will be accepted. When this
present value. Capital budgeting preference is done, the cost of capital is used as the
decisions relate to choosing between several discount rate in discounted cash flow analysis. If
competing courses of action, such as which of the net present value of the project is positive,
two machines to purchase. then the project is acceptable, since its rate of
return will be greater than the cost of capital.
12-2 The term “time value of money” refers
to the fact that a dollar received today is more 12-9 No. As the discount rate increases, the
valuable than a dollar received in the future. A present value of a given future cash flow
dollar received today can be invested to decreases. For example, the factor for a
generate a return, yielding more than a dollar in discount rate of 12% for cash to be received ten
a future period. years from now is 0.322, whereas the factor for
a discount rate of 14% over the same period is
12-3 Discounting is the process of computing 0.270. If the cash to be received in ten years
the present value of a future cash flow. The was $10,000, the present value in the first case
concept gives specific recognition to the time would be $3,220, but only $2,700 in the second
value of money in investment decisions. case. Thus, as the discount rate increases, the
present value of a given cash flow decreases.
12-4 The net present value method is
superior because it gives specific recognition to 12-10 The return is more than 14%. This is
the time value of money. apparent since the net present value is positive.
In order for the rate of return to be exactly
12-5 Net present value is the present value of 14%, the net present value would have to be
cash inflows less the present value of cash zero.
outflows. The net present value can be negative
if the present value of the outflows is greater 12-11 Preference decisions are sometimes
than the present value of the inflows. called rationing decisions since funds available
for investment are often limited and it is
12-6 No. Cost of capital is not simply the necessary to ration these funds among many
interest paid on long-term debt. The cost of competing investment opportunities.
capital is a weighted average of the costs of all
sources of financing, both debt and equity. 12-12 The profitability index is computed by
dividing the present value of the cash inflows
12-7 The internal rate of return is the rate of from an investment project by the present value
return of an investment project over its useful of the investment required. The index measures
life. It is computed by finding the discount rate the profitability provided of each dollar of
that equates the present value of a project’s investment in a project.
cash inflows with the present value of its cash
outflows. 12-13 The higher the profitability index, the
more desirable the investment project.

© The McGraw-Hill Companies, Inc., 2005. All rights reserved.

Solutions Manual, Chapter 12 11
12-14 No. If the profitability index is less than useful to firms that are experiencing difficulties
1.00, then the net present value of the project is in maintaining a strong cash position. It can help
negative, indicating that it does not provide the identify projects that will return the initial
required minimum rate of return. investment very quickly, thus helping in the
management of short-term cash flows. The
12-15 The payback period is the length of time payback method is often used in industries
that it takes for an investment to recoup its own where products become obsolete very rapidly.
initial cost out of the cash receipts that it
generates. 12-17 Neither the payback nor the simple rate
of return method considers the time value of
12-16 The payback method can help the money. A dollar received today is weighed
manager by acting as a screening tool in equally with a dollar received in the future.
weeding out investment proposals. If a proposal Furthermore, the payback method ignores all
doesn’t provide a payback within some specified cash flows that occur after the initial investment
period, there may be no need to consider it has been recovered.
further. Also, the payback method is often very

© The McGraw-Hill Companies, Inc., 2005. All rights reserved.

12 Introduction to Managerial Accounting, 2nd Edition
Brief Exercise 12-1 (15 minutes)
1.
Present
Value of
Cash 14% Cash
Item Year(s) Flow Factor Flows
Annual cost savings 1- 10 $ 4,000 5.216 $ 20,864
Initial investment Now (25,000) 1.000 (25,000)
Net present value $ (4,136)

2.
Total
Cash Cash
Item Flow Years Flows
Annual cost savings $ 4,000 10 $ 40,000
Initial investment (25,000) 1 (25,000)
Net cash flow $ 15,000
Brief Exercise 12-2 (20 minutes)

Present
Amount of 16% Value of
Item Year(s) Cash Flows Factor Cash Flows
Project A:
Investment required Now $(15,000) 1.000 $(15,000)
Annual cash inflows 1-10 4,000 4.833 19,332
Net present value $  4,332

Project B:
Investment Now $(15,000) 1.000 $(15,000)
Cash inflow 10 60,000 0.227 13,620
Net present value $ (1,380)
Project A should be selected. Project B does not provide the required 16%
return, as shown by its negative net present value.

Alternatively, the profitability indexes of the projects can be computed.

Profitability = Present value of cash inflows
index Investment required
Project A:
Profitability = $19,332 = 1.289
index $15,000
Project B:
Profitability = $13,620 = 0.908
index $15,000

Project A is preferred since its profitability index is higher.

Brief Exercise 12-3 (15 minutes)
1. The profitability index for each proposal would be:
Present Value of Investment Profitability
Cash Inflows Required Index
Proposal (a) (b) (a) ÷ (b)
A $119,000 $85,000 1.40
B $184,000 $200,000 0.92
C $135,000 $90,000 1.50
D $221,000 $170,000 1.30

2. The ranking would be:

Profitability
Proposal Index
C 1.50
A 1.40
D 1.30
B 0.92
Two points should be noted about the ranking. First, proposal B is not
an acceptable proposal at all, since it has a profitability index of less
than 1.0 (negative net present value). Second, proposal D has the
highest net present value, but it ranks lowest of the three acceptable
proposals in terms of the profitability index.
Brief Exercise 12-4 (15 minutes)
1. The payback period is determined as follows:
Beginning Ending
Unrecovered Cash Unrecovered
Year Investment Investment Inflow Investment
1 $0 $38,000 $2,000 $36,000
2 $36,000 $6,000 $4,000 $38,000
3 $38,000 $8,000 $30,000
4 $30,000 $9,000 $21,000
5 $21,000 $12,000 $9,000
6 $9,000 $10,000 $0
7 $0 $8,000 $0
8 $0 $6,000 $0
9 $0 $5,000 $0
10 $0 $5,000 $0
The investment in the project is fully recovered in the 6th year. To be
more exact, the payback period is approximately 6.9 years.

2. Since the investment is recovered prior to the last year, the amount of
the cash inflow in the last year has no effect on the payback period.
Brief Exercise 12-5 (15 minutes)
This is a cost reduction project, so the simple rate of return would be
computed as follows:

Cost of the new machine $80,000

Scrap value of old machine 5,000
Initial investment $75,000
Operating cost of old machine $33,000
Operating cost of new machine 10,000
Annual cost savings $23,000
Cost of new machine $80,000
Less salvage value 0
Depreciable cost of new machine 80,000
Useful life of new machine 10 years
Annual depreciation on new machine $ 8,000 per year
Simple rate = Cost savings - Depreciation on new equipment
of return Initial investment
$23,000 - $8,000
= = 20%
$75,000
Brief Exercise 12-6 (30 minutes)
1. a. $400,000 × 0.794 (Table 12B-3) = $317,600.
b. $400,000 × 0.712 (Table 12B-3) = $284,800.

2. a. $5,000 × 4.355 (Table 12B-4) = $21,775.

b. $5,000 × 3.685 (Table 12B-4) = $18,425.

3. Looking in Table 12B-4, the factor for 10% for 20 years is 8.514. Thus,
the present value of Sally’s winnings would be:
$50,000 × 8.514 = $425,700.
Whether or not Sally really won a million dollars depends on your point
of view. She will receive a million dollars over the next 20 years;
however, in terms of its value right now she won much less than a
million dollars as shown by the present value computation above.
Exercise 12-7 (30 minutes)

Present
Amount Value of
of Cash 14% Cash
Item Year(s) Flows Factor Flows
Cost of equipment required Now $(850,000) 1.000 $(850,000)
Working capital required Now (100,000) 1.000 (100,000)
Net annual cash receipts 1-5 230,000 3.433 789,590
Cost of road repairs 3 (60,000) 0.675 (40,500)
Salvage value of equipment 5 200,000 0.519 103,800
Working capital released 5 100,000 0.519 51,900
Net present value $ (45,210)
No, the project should not be accepted; it has a negative net present
value. This means that the rate of return on the investment is less than the
company’s required rate of return of 14%.
Exercise 12-8 (20 minutes)

Present
Amount Value of
of Cash 20% Cash
Item Year(s) Flows Factor Flows
Project A:
Cost of the equipment Now $(300,000) 1.000 $(300,000)
Annual cash inflows 1-7 80,000 3.605 288,400
Salvage value of the equipment 7 20,000 0.279 5,580
Net present value $  (6,020)

Project B:
Working capital investment Now $(300,000) 1.000 $(300,000)
Annual cash inflows 1-7 60,000 3.605 216,300
Working capital released 7 300,000 0.279 83,700
Net present value $ 0

The $300,000 should be invested in Project B rather than in Project A.

Project B has a zero net present value, which means that it promises
exactly a 20% rate of return. Project A is not acceptable at all, since it has
a negative net present value.
Exercise 12-9 (30 minutes)
1. The formula for the profitability index is:
Present value of cash inflows
Profitability index =
Investment required
The index for the projects under consideration would be:

Project 1: $567,270 ÷ $480,000 = 1.18

Project 2: $433,400 ÷ $360,000 = 1.20
Project 3: $336,140 ÷ $270,000 = 1.24
Project 4: $522,970 ÷ $450,000 = 1.16
Project 5: $379,760 ÷ $400,000 = 0.95

2. a., b., and c.

Net Present Profitability
Value Index
First preference 1 3
Second preference
2 2
Third preference 4 1
Fourth preference
3 4
Fifth preference 5 5
Exercise 12-9 (continued)
3. Which ranking is best will depend on Lake Union Yacht Brokers’
opportunities for reinvesting funds as they are released from a project.
The profitability index approach assumes that funds released from a
project are reinvested in other projects. But the assumption is that the
return earned by these other projects is equal to the discount rate,
which in this case is only 10%. On balance, the profitability index is
generally regarded as being the most dependable method of ranking
competing projects.
The net present value is inferior to the profitability index as a ranking
device, since it looks only at the total amount of net present value from
a project and does not consider the amount of investment required. For
example, it ranks project #3 as fourth in terms of preference because of
its low net present value; yet this project is the best available in terms
of the amount of cash inflow generated for each dollar of investment (as
shown by the profitability index).
Exercise 12-10 (20 minutes)
1. The payback period would be:
Investment required
Payback Period =
Net annual cash inflow
$180,000
= = 4.8 years
$37,500 per year
No, the equipment would not be purchased, since the 4.8-year payback
period exceeds the company’s maximum 4.0-year payback.
2. The simple rate of return would be:
Cost savings - Depreciation
Simple rate of return =
Initial Investment
$37,500 - $15,000*
= = 12.5%
$180,000
*180,000 ÷ 12 years = $15,000 per year.
No, the equipment would not be purchased since its 12.5% rate of return
is less than the company’s 14% minimum required rate of return.
Exercise 12-11 (15 minutes)

Amount of 12% Present Value

Year(s) Cash Flows Factor of Cash Flows
Purchase of the stock Now $(18,000) 1.000 $(18,000)
Annual dividends* 1-4 720 3.037 2,187
Sale of the stock 4 22,500 0.636 14,310
Net present value $(1,503)
*900 shares × $0.80 per share per year = $720 per year.
No, Mr. Critchfield did not earn a 12% return on the stock. The negative
net present value indicates that the rate of return on the investment is less
than the discount rate of 12%.
Problem 12-12 (30 minutes)
1. The net annual cash inflows would be:
Reduction in annual operating costs:
Operating costs, present hand method.......................... $24,000
Operating costs, new machine......................................6,500
Annual savings in operating costs..................................
17,500
Increased annual contribution margin:
5,500 boxes × $2.10 per box........................................
11,550
Total net annual cash inflows..........................................
$29,050

2. Present
Amount of 18% Value of
Item Year(s) Cash Flows Factor Cash Flows
Cost of the machine Now $(100,000) 1.000 $(100,000)
Replacement of parts 5 (7,000) 0.437 (3,059)
Annual cash inflows
(above) 1-10 29,050 4.494 130,551
Salvage value of the
machine 10 6,000 0.191 1,146
Net present value $ 28,638
Problem 12-13 (45 minutes)
1. Average weekly use of the auto wash and the vacuum will be:
$1,110
Auto wash: = 740 uses; Vacuum: 740 × 70% = 518 uses
$1.50
The expected net annual cash receipts will be:
Auto wash cash receipts ($1,110 per week × 52
weeks)........................................................................ $57,720
Vacuum cash receipts (518 vacuumings per week ×
$0.25 per vacuuming × 52 weeks)................................ 6,734
Total cash receipts.......................................................... 64,454
Less cash disbursements:
Washer (740 washings per week × $0.23 per
washing × 52 weeks)................................................ $ 8,850
Electricity (518 vacuumings per week × $0.10 per
vacuuming × 52 weeks)............................................. 2,694
Rent ($1,200 per month × 12 months).......................... 14,400
Cleaning ($780 per month × 12 months)....................... 9,360
Insurance ($60 per month × 12 months)....................... 720
Maintenance ($510 per month × 12 months)................. 6,120
Total cash disbursements................................................ 42,144
Net annual cash receipts................................................. $22,310

2. Amount of Present
Cash 12% Value of
Item Year(s) Flows Factor Cash Flows
Cost of equipment Now $(110,000) 1.000 $(110,000)
Working capital needed
Now (1,800) 1.000 (1,800)
Net annual cash receipts
(above) 1-10 22,310 5.650 126,052
Salvage of equipment 10 11,000 0.322 3,542
Working capital released
10 1,800 0.322 580
Net present value $ 18,374
Yes, Jerry should open the car wash. It promises more than a 12% rate
of return.
Problem 12-14 (45 minutes)
1. The total-cost approach:
Present
Amount of 16% Value of
Item Year(s) Cash Flows Factor Cash Flows
Purchase the new truck:
Initial investment— new
truck Now $(42,000) 1.000 $(42,000)
Salvage of the old truck
Now 10,000 1.000 10,000
Annual cash operating
costs 1-10 (11,000) 4.833 (53,163)
Salvage of the new truck
10 4,000 0.227 908
Present value of the net
cash outflows $(84,255)
Keep the old truck:
Overhaul needed now Now $ (9,500) 1.000 $ (9,500)
Annual cash operating
costs 1-10 (14,000) 4.833 (67,662)
Salvage of the old truck
10 2,000 0.227 454
Present value of the net
cash outflows $ (76,708)
Net present value in favor of
keeping the old truck $ 7,547
The company should keep the old truck.
Problem 12-14 (continued)
2. The incremental-cost approach:
Amount Present
of Cash 16% Value of
Item Year(s) Flows Factor Cash Flows
Incremental investment—new
truck*................................... Now $(32,500) 1.000 $(32,500)
Salvage of the old truck............ Now 10,000 1.000 10,000
Savings in annual cash
operating costs...................... 1-10 3,000 4.833 14,499
Difference in salvage value in
10 years............................... 10 2,000 0.227 454
Net present value in favor of
keeping the old truck............. $ (7,547)
*$42,000 – $9,500 = $32,500. The $10,000 salvage value now of the
old truck could also be deducted, leaving an incremental investment for
the new truck of only $22,500.
Problem 12-15 (45 minutes)
The net annual cash inflow from rental of the property would be:
Net income $30,100
Add back depreciation 17,800
Net annual cash inflow $47,900
Given this figure, the present value analysis would be as follows:
Present
Amount Value of
of Cash 14% Cash
Item Year(s) Flows Factor Flows
Keep the property:
Annual loan payment 1-10 $(12,600) 5.216 $ (65,722)
Net annual cash inflow
1-16 47,900 6.265 300,094
Resale value of the
property 16 139,600 * 0.123 17,171
Present value of cash
flows $251,543
Sell the property:
Pay-off of mortgage Now $(71,000) 1.000 $ (71,000)
Down payment received
Now 150,000 1.000 150,000
Annual payments
received 1-16 23,000 6.265 144,095
Present value of cash
flows $223,095
Net present value in favor
of keeping the property
$ 28,448
*Land: $52,000 × 2.5 = $130,000; Building: $9,600; Total: $139,600.
Thus, Professor Ryatt should be advised to keep the property. Note that
even if the property were worth nothing at the end of 16 years, it would
still be more desirable to keep the property rather than sell it under the
terms offered by the realty company.
Problem 12-16 (30 minutes)
1. The formula for the profitability index is:
Profitability = Present value of cash inflows
index Investment required
The profitability index for each project would be:
Project A: $140,000 + $42,000 = $182,000;
$182,000 ÷ $140,000 = 1.30
Project B: $190,000 + $49,400 = $239,400;
$239,400 ÷ $190,000 = 1.26
Project C: $175,000 + $49,000 = $224,000;
$224,000 ÷ $175,000 = 1.28
Project D: $132,000 + $(2,640) = $129,360;
$129,360 ÷ $132,000 = 0.98
Project E: $138,000 + $31,740 = $169,740;
$169,740 ÷ $138,000 = 1.23

2. a. and b.
Net Present Profitability
Value Index
First preference B A
Second preference
C C
Third preference A B
Fourth preference
E E
Fifth preference D D

3. The net present value method looks only at the total amount of net
present value from a project. When investment funds are limited,
investments should be made in the projects that promise the greatest
return per dollar invested. This is the approach taken with the
profitability index. For example, project A is ranked third on the basis of
net present value; yet this project is ranked first in terms of the amount
of cash inflow generated for each dollar of investment (as shown by the
profitability index).
Problem 12-17 (30 minutes)
1. The incremental income statement would be:
Ticket revenue................................................................ $320,000
Less operating expenses:
Salaries.......................................................................
$115,000
Insurance....................................................................
28,200
Utilities........................................................................
12,000
Depreciation*..............................................................
50,000
Maintenance................................................................
32,000
Total operating expenses................................................237,200
Net operating income...................................................... $ 82,800
*$500,000 ÷ 10 years = $50,000 per year.
2. The simple rate of return would be:
Simple rate = Net income
of return Initial Investment-Salvage from old equipment

$82,800
= = 18.0%
$500,000 - $40,000
Yes, the water slide would be constructed. Its return is greater than the
specified hurdle rate of 15%.

3. The payback period would be:

Payback = Initial investment - Salvage from old equipment
period Net annual cash inflow
$500,000 - $40,000
= = 3.46
$132,800*
*Net operating income+ Depreciation = $82,800 + $50,000 = $132,800
Yes, the water slide would be constructed. The payback period is within
the maximum 5 years Otthar requires.
Problem 12-18 (60 minutes)
1.
a. Sales revenue.................................................................$350,000
Less variable production expenses (@ 20%).................... 70,000
Contribution margin........................................................ 280,000
Less fixed expenses:
Advertising..................................................................
$42,000
Salaries.......................................................................
86,000
Utilities........................................................................
9,000
Insurance....................................................................
13,000
Depreciation*..............................................................
58,500
Total fixed expenses....................................................... 208,500
Net operating income......................................................$ 71,500
[$780,000 – (25% × $780,000)] ÷ 10 years = $58,500 per year

b. The formula for the simple rate of return is:

Incremental - Incremental expenses,
Simple rate = revenue including depreciation
of return Initial Investment
Incremental net operating income
=
Initial investment
$71,500
= = 9.2%
$780,000
c. The formula for the payback period is:
Investment required
Payback period =
Net annual cash inflow
$780,000
= = 6.0 years
$130,000 per year*
*Net annual cash inflow = Net operating income + Depreciation
= $71,500 + $58,500 = $130,000
Problem 12-18 (continued)
2. a. A cost reduction project is involved here, so the formula for the
simple rate of return would be:
Cost savings - Depreciation
Simple rate of return =
Initial - Salvage from
investment old equipment
The reduction in costs with the new equipment would be:
Annual costs, old equipment............................................
$85,000
Annual costs, new equipment:
Salary of operator........................................................
$26,000
Maintenance................................................................
3,000 29,000
Annual savings in costs...................................................
$56,000
Thus, the simple rate of return would be:
$56,000 - $22,000* $34,000
= = 16.0%
$220,000 - $7,200 $212,800
*$220,000 ÷ 10 years = $22,000 per year

b. The formula for the payback period remains the same as in Part (1),
except we must reduce the investment required by the salvage from
sale of the old equipment:
Investment - Salvage from
required old equipment
Payback period =
Net annual cash inflow
$220,000 - $7,200
= = 3.8 years
$56,000 per year*
*See Part (2a) above.

3. According to the company’s criteria, machine A should not be purchased

and machine B should be purchased.
Problem 12-19 (60 minutes)
1. A net present value computation for each investment follows:
Present
Amount of 20% Value of
Item Year(s) Cash Flows Factor Cash Flows
Common stock:
Purchase of the stock Now $(80,000) 1.000 $(80,000)
Sale of the stock 4 180,000 0.482 86,760
Net present value $ 6,760
Preferred stock:
Purchase of the stock Now $(30,000) 1.000 $(30,000)
Annual cash dividend
(6%) 1-4 1,800 2.589 4,660
Sale of the stock 4 24,000 0.482 11,568
Net present value $(13,772)
Bonds:
Purchase of the bonds
Now $(50,000) 1.000 $(50,000)
Semiannual interest
received 1-8* 3,000 5.335** 16,005
Sale of the bonds 8* 58,500 0.467** 27,320
Net present value $ (6,675)
* 8 semiannual interest periods.
** Factor for 8 periods at 10%. (As stated in the text, we must
halve the discount rate and double the number of periods.)

Anita earned a 20% rate of return on the common stock, but not on the
preferred stock or the bonds.
Problem 12-19 (continued)
2. Considering all three investments together, Anita did not earn a 20%
rate of return. The computation is:
Net
Present
Value
Common stock $ 6,760
Preferred stock (13,772)
Bonds (6,675)
Overall net present value $(13,687)
The defect in the broker’s computation is that it does not consider the
time value of money and therefore has overstated the rate of return
earned.

3. Since the assumption is that the project will yield the same annual cash
inflow every year, the formula for the net present value of the project is:
Net present Present value Annual
value of = factor for × cash - Investment
the project an annuity inflow required

Substituting the $262,500 investment and the factor for 16% for 10
periods into this formula and requiring that the net present value be
positive, we get:
4.833 × Annual cash inflow – $262,500 > 0
Therefore, the required net annual cash inflow would be at least:
Annual cash inflow > $262,500 ÷ 4.833 = $54,314
Analytical Thinking Case (60 minutes)
1. Some students will have difficulty organizing the data into a coherent
format. Perhaps the clearest approach is as follows:
Amount of 12% Present Value
Item Year(s) Cash Flows Factor of Cash Flows
Purchase of facilities:
Initial payment Now $(6,000,000) 1.000 $ (6,000,000)
Annual payments 1-4 (2,000,000) 3.037 (6,074,000)
Annual cash operating
costs 1-20 (200,000) 7.469 (1,493,800)
Resale value of
facilities 20 5,000,000 0.104 520,000
Present value of cash
flows $(13,047,800)
Lease of facilities:
Initial deposit Now $ (400,000) 1.000 $ (400,000)
First lease payment Now (1,000,000) 1.000 (1,000,000)
Remaining lease
payments 1-19 (1,000,000) 7.366 (7,366,000)
Annual repair and
maintenance 1-20 (50,000) 7.469 (373,450)
Return of deposit 20 400,000 0.104 41,600
Present value of cash
flows $ (9,097,850)
Net present value in
favor of leasing the
facilities $ 3,949,950
This is a least-cost decision. In this particular case, the simplest way to
handle the data is the total-cost approach as shown above. The problem
with Harry Wilson’s approach, in which he simply added up the
payments, is that it ignores the time value of money. The purchase
option ties up large amounts of funds that could be earning a return
elsewhere.
Analytical Thinking Case (continued)
The incremental-cost approach is another way to organize the data,
although it is harder to follow and would not be as clear in a
presentation to the executive committee. The data could be arranged as
follows (students are likely to have many variations):
Lease rather than buy:
Present
Amount of 12% Value of
Item Year(s) Cash Flows Factor Cash Flows
Initial payment avoided1 Now $5,000,000 1.000 $ 5,000,000
Deposit Now (400,000) 1.000 (400,000)
Annual purchase
payments avoided 1-4 2,000,000 3.037 6,074,000
Annual lease payments 1-19 (1,000,000) 7.366 (7,366,000)
Cash operating cost
savings2 1-20 150,000 7.469 1,120,350
Forgone resale value of
facilities, net of the
return of deposit3 20 (4,600,000) 0.104 (478,400)
Net present value in favor
of leasing the facilities
$ 3,949,950
1
$6,000,000 – $1,000,000 = $5,000,000
2
$200,000 – $50,000 = $150,000
3
$5,000,000 – $400,000 = $4,600,000

2. The present value of $5 million in 20 years is only $520,000 if the

company can invest its funds at 12%. Money to be received far into the
future is worth very little in terms of present value when the discount
rate is high. The facility’s future value would have to be more than
$37,980,000 (= $3,949,950 ÷ 0.104) higher than Harry Wilson has
assumed to overturn the conclusion that leasing is the more attractive
alternative.
Teamwork in Action
1. This is a least-cost problem; it can be worked either by the total-cost approach or by the incremental-
cost approach. Regardless of which approach is used, we must first compute the annual production
costs that would result from each of the machines. The computations are:
Year
1 2 3 4-10
Units produced...............................................................
20,000 30,000 40,000 45,000
Model 2600: Total cost at $0.90 per unit..........................
$18,000 $27,000 $36,000 $40,500
Model 5200: Total cost at $0.70 per unit..........................
$14,000 $21,000 $28,000 $31,500
Using these data, the solution by the total-cost approach would be:
Amount of 18% Present Value
Item Year(s) Cash Flows Factor of Cash Flows
Alternative 1: Purchase the model 2600 machine:
Cost of new machine....................................................
Now $(180,000) 1.000 $(180,000)
Cost of new machine....................................................
6 (200,000) 0.370 (74,000)
Market value of replacement machine........................... 10 100,000 0.191 19,100
Production costs (above)..............................................
1 (18,000) 0.847 (15,246)
   "  "  ...............................................................
2 (27,000) 0.718 (19,386)
   "  "  ...............................................................
3 (36,000) 0.609 (21,924)
   "  "  ...............................................................
4-10 (40,500) 2.320 * (93,960)
Repairs and maintenance.............................................
1-10 (6,000) 4.494 (26,964)
Present value of cash outflows...................................... $(412,380)

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38 Introduction to Managerial Accounting, 2nd Edition
Teamwork in Action (continued)

Amount of 18% Present Value

Item Year(s) Cash Flows Factor of Cash Flows
Alternative 2: Purchase the model 5200 machine:
Cost of new machine....................................................
Now $(250,000) 1.000 $(250,000)
Production costs (above)..............................................
1 (14,000) 0.847 (11,858)
   "  "  ...............................................................
2 (21,000) 0.718 (15,078)
   "  "  ...............................................................
3 (28,000) 0.609 (17,052)
   "  "  ...............................................................
4-10 (31,500) 2.320 * (73,080)
Repairs and maintenance.............................................
1-10 (4,600) 4.494 (20,672)
Present value of cash outflows...................................... $(387,740)
Net present value in favor of Alternative 2........................ $  24,640
* Present value factor for 10 periods............................................................ 4.494
Present value factor for  3 periods............................................................ 2.174
Present value factor for  7 periods starting 4 periods in the future............. 2.320

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Solutions Manual, Chapter 12 39
Teamwork in Action (continued)
The solution by the incremental-cost approach would be:
Present
Amount Value of
of Cash 18% Cash
Item Year(s) Flows Factor Flows
Incremental cost of the
model 5200 machine Now $ (70,000) 1.000 $ (70,000)
Cost avoided on a replace-
ment model 2600 machine 6 200,000 0.370 74,000
Salvage value forgone on the
replacement machine 10 (100,000) 0.191 (19,100)
Savings in production costs 1 4,000 0.847 3,388
 "  "  "   2 6,000 0.718 4,308
 "  "  "   3 8,000 0.609 4,872
 "  "  "   4-10 9,000 2.320 20,880
Savings on repairs, etc. 1-10 1,400 4.494 6,292
Net present value $  24,640
Thus, the company should purchase the model 5200 machine and keep
the presently owned model 2600 machine on standby.

2. An increase in materials cost would make the model 5200 machine less
desirable. The reason is that it uses more material per unit than does
the model 2600 machine, as evidenced by the greater material cost per
unit.

3. An increase in labor cost would make the model 5200 machine more
desirable. The reason is that it uses less labor time per unit than does
the model 2600 machine, as evidenced by the lower labor cost per unit.

© The McGraw-Hill Companies, Inc., 2005. All rights reserved.

40 Introduction to Managerial Accounting, 2nd Edition
Communication in Practice

Date: Current date

To: Instructor
From: Student’s Name
Subject: Capital Budgeting Discussion with
Controller or Chief Financial Officer

In addition to summarizing general information about the company (that

was obtained from the company’s web site), each student’s memorandum
should address the following:

1. The nature of the capital project.

2. The total cost of the capital project.
3. Whether or not the project costs stayed within budget.
4. The financial criteria used to evaluate the project.

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Solutions Manual, Chapter 12 41
© The McGraw-Hill Companies, Inc., 2005. All rights reserved.
42 Introduction to Managerial Accounting, 2nd Edition