CHAPTER 14
CAPITAL BUDGETING
SHORT ANSWER/PROBLEMS
1. In a net present value analysis, how can an analyst explicitly and formally consider the
influence of risk on the present value of certain cash flows?
ANSWER: An analyst could do at least three different things to explicitly account
for risk. The analyst could: (1) adjust the discount rate to reflect the risk of the cash flow,
(2) adjust the discounting period of the cash flow, or (3) adjust the expected amount of
the cash flow up or down to reflect the risk.
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2. What factors influence the present value of the depreciation tax benefit?
ANSWER: The depreciation tax benefit is primarily affected by three factors: the
depreciation rate or method, the tax rate, and the discount rate.
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3. Why is it important for managers to be able to rank projects?
ANSWER: Managers need to be able to rank projects for two primary reasons. First,
managers need to be able to select the best project from a set of projects that are directly
competing with each other (particularly in the case of mutually exclusive projects).
Second, even when projects are not directly competing with each other, managers may
have a limited supply of capital that has to be allocated to the most worthy of the
projects.
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4. If it is assumed that managers act to maximize the value of the firm, what can also be
assumed about the existing mix of capital components relative to the set of all viable
alternative mixes of capital components?
ANSWER: It can be assumed that the existing mix of capital components is the one
that minimizes the cost of capital (which, therefore, maximizes the value of the firm).
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5. Does a project that generates a positive internal rate of return also have a positive net
present value? Explain.
ANSWER: No. A positive IRR does not necessarily mean that a project will also have
a positive NPV. Only if the IRR is greater than the discount rate that is used in the NPV
calculation will the NPV be positive.
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6. Why is the profitability index a better basis than net present value to compare projects
that require different levels of investment?
ANSWER: The profitability index relates the magnitude of the net present value to
the magnitude of the initial investment. Thus, the PI gives some indication of relative
profitability. The NPV itself provides no direct indication of the level of investment that
is required to generate the NPV and therefore provides no indication of relative
profitability.
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7. (Appendix) What is the major advantage of the accounting rate of return relative to the
other techniques that can be used to evaluate capital projects?
ANSWER: The accounting rate of return has two major advantages relative to the
other capital budgeting techniques. First, it may be more compatible as an investment
criterion with criteria that are used to evaluate managerial and segment performance
particularly for investment centers that are evaluated on an ROI or RI basis. Second, the
accounting rate of return can be generated from accounting data and is therefore easy to
track over the life of the investment.
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8. Why is it important for organizations to conduct post investment audits of capital
projects?
ANSWER: The post investment audit provides management with an opportunity to
evaluate the actual performance of the investment relative to expected performance. If
possible, management can take corrective action when actual performance is poor
relative to the expected performance. Management can also use the post investment audit
to evaluate the performance of those who provided the original information about the
investment and those who are in charge of the investment. In addition, management may
use the information from the post investment audit to improve the evaluation process of
future capital projects.
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9. How are capital budgeting models affected by potential investments in automated
equipment investment decisions?
ANSWER: Discount rates for present value calculations often far exceed a firm’s cost
of capital. Automated machinery is very costly and may be at a disadvantage in
discounted cash flow methods. Qualitative factors associated with automated equipment
may not receive any weight or value in current capital budgeting methods. Automated
equipment is often interrelated with other investments and should be bundled to reflect
this synergism. Finally, there is the opportunity cost of not automating when competitors
automate and your firm doesn’t.
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10. (Present value tables needed to answer this question.) Managers of the Jonathan Co.
realize that the present value of the depreciation tax benefit is affected by the discount rate, the
tax rate, and the depreciation rate. They have recently purchased a machine for $100,000 and
they are trying to decide which depreciation method to use. There are only two alternatives
available, and they must make an irrevocable selection of one method or the other right now.
They have no uncertainty about the company’s discount rate (it is 10 percent), but they are
highly uncertain about the direction of future tax rates. The company’s uncertainty stems from
the fact that the existing tax rate is 30 percent, but congress is presently debating tax legislation
that would dramatically increase the rate. If the legislation is passed it would go into affect in
two years (after the Jonathan Co. has claimed two years of depreciation). How high would tax
rates need to be in two years for the Jonathan Co. to be indifferent between depreciation Method
2 and depreciation Method 1 below?
Method 1 Method 2 Difference
Year 1 $30,000 $10,000 $(20,000)
Year 2 $40,000 $15,000 $(25,000)
Year 3 $10,000 $25,000 $15,000
Year 4 $10,000 $25,000 $15,000
Year 5 $10,000 $25,000 $15,000
ANSWER: No matter what happens, the tax rate for the next two years is 30 percent.
Using the differences in depreciation amounts, one can determine the difference in
present values between the two methods at the end of year 2 when the tax rate is expected
to change.
Present value calculations for years 1 and 2:
Year 1 ($20,000) × .30 × .9091 = $ (5,455)
Year 2 ($25,000) × .30 × .8265 = $ (6,199)
Total present value difference at end $ (11,654)
So, after the first two years, Method 1 has generated $11,654 more present value than
Method 2. This simply means that at the point of indifference, Method 2 would be
required to generate $11,654 more present value than Method 1 in the last three years.
For the last three years of the project’s life, the difference in depreciation amounts is
$15,000. This $15,000 amount can be used in the following equation to solve for the tax
rate that yields a present value of $11,654:
$11,654 = $15,000 × tax rate × (.7513 + .6830 + .6209)
$11,654 = $30,828 × tax rate
Tax rate = $11,654/$30,828
Tax rate = 37.8%
Thus, an increase in the tax rate to about 37.8 percent would cause management to be
indifferent between the two depreciation methods.
DIFFICULT
Use the following information for question 11.
XL Corp. is considering an investment that will require an initial cash outlay of $200,000 to
purchase non-depreciable assets. The project promises to return $60,000 per year (after-tax) for
eight years with no salvage value. The company’s cost of capital is 11 percent.
11. (Present value tables needed to answer this question.) The company is uncertain about its
estimate of the life expectancy of the project. How many years must the project generate
the $60,000 per year return for the company to at least be indifferent about its
acceptance? (Do not consider the possibility of partial year returns.)
ANSWER: Dividing $200,000/$60,000, gives the annuity discount factor (3.3333) for
11 percent associated with the minimal required time for this project to be successful.
According to the tables in Appendix A, the project will have a positive net present value
if the cash flows last through year 5.
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Use the following information for questions 12–14.
Treble Co. is considering an investment in a new product line. The investment would require an
immediate outlay of $100,000 for equipment and an immediate investment of $200,000 in
working capital. The investment is expected to generate a net cash inflow of $100,000 in year 1,
$150,000 in year 2, and $200,000 in years 3 and 4. The equipment would be scrapped (for no
salvage) at the end of the fourth year and the working capital would be liquidated. The
equipment would be fully depreciated by the straight-line method over its four-year life.
12. (Present value tables needed to answer this question.) If Treble uses a discount rate of 16
percent, what is the NPV of the proposed product line investment?
ANSWER:
Cash flow Year Amount Discount factor Present value
Investment 0 $(100,000) 1.00 $(100,000)
Working cap. 0 $(200,000) 1.00 (200,000)
Cash inflow 1 100,000 .8621 86,210
Cash inflow 2 150,000 .7432 111,480
Cash inflow 3 200,000 .6407 128,140
Cash inflow 4 200,000 .5523 110,460
Working cap. 4 200,000 .5523 110,460
Net present value $246,750
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13. What is the payback period for the investment?
ANSWER: After the first two years, $250,000 of the original $300,000 investment
would be recouped. It would take one-quarter of the third year ($50,000/$200,000) to
recoup the last $50,000. Thus, the payback period is 2.25 years.
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14. (Present value tables needed to answer this question.) Jane has an opportunity to invest in
a project that will yield four annual payments of $12,000 with no salvage. The first
payment will be received in exactly one year. On low-risk projects of this type, Jane
requires a return of 6 percent. Based on this requirement, the project generates a
profitability index of 1.03953.
a. How much is Jane required to invest in this project?
b. What is the internal rate of return on Jane’s project?
ANSWER:
a. The present value of the $12,000 annuity is found by multiplying $12,000 by the
annuity discount factor associated with 6 percent interest for four years: $12,000
× 3.4651 = $41,581.20.
From the information on the profitability index, it is known that the present value
of the cash inflows is 1.03953 times the initial investment. Thus, the initial
investment is$41,581.20/1.03953 = $40,000.
b. By dividing $40,000 by the annual cash inflow of $12,000, it is determined that
the discount factor associated with the IRR is 3.3333. This discount factor is
associated with an interest rate that lies between 7 and 8 percent. Using
interpolation, the IRR is computed to be approximately 7.72 percent.
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15. (Present value tables needed to answer this question.) Wood Productions is considering
the purchase of a new movie camera, which will be used for major motion pictures. The
new camera will cost $30,000, have an eight-year life, and create cost savings of $5,000
per year. The new camera will require $700 of maintenance each year. Wood
Productions uses a discount rate of 9 percent.
a. Compute the net present value of the new camera.
b. Determine the payback period.
ANSWER:
a. Cost savings per year $5,000
Maintenance per year (700 )
Net cash flows per year $4,300
Cash Discount factor Present value
$30,000 1.0000 $(30,000.00)
4,300 5.5348 23,799.64
Net present value of investment $ (6,200.36)
b. Payback equals $30,000/$4,300 = 6.976 years
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16. (Present value tables needed to answer this question.) XYZ Co. is interested in
purchasing a state-of-the-art widget machine for its manufacturing plant. The new
machine has been designed to basically eliminate all errors and defects in the widget-
making production process. The new machine will cost $150,000, and have a salvage
value of $70,000 at the end of its seven-year useful life. XYZ has determined that cash
inflows for years 1 through 7 will be as follows: $32,000; $57,000; $15,000; $28,000;
$16,000; $10,000, and $15,000, respectively. Maintenance will be required in years 3
and 6 at $10,000 and $7,000 respectively. XYZ uses a discount rate of 11 percent and
wants projects to have a payback period of no longer than five years.
a. Compute the net present value of the new machine.
b. Compute the firm’s profitability index.
c. Compute the payback period.
d. Evaluate this investment proposal for XYZ Co.
ANSWER:
a. Year Cash flow Discount factor Present value
1 $150,000 1.0000 $(150,000.00)
1 32,000 .9009 28,828.80
2 57,000 .8116 46,261.20
3 5,000 .7312 3,656.00
4 28,000 .6587 18,443.60
5 16,000 .5935 9,496.00
6 3,000 .5346 1,603.80
7 15,000 .4817 7,225.50
7 70,000 .4817 33,719.00
Net present value $ (766.10)
b. Profitability index equals present value of cash flows divided by investment:
$149,233.90/$150,000 = .995
c. Payback period is 6.11 years, computed as follows:
Year Cash Flow Cumulative Cash Flow
1 $32,000 $ 32,000
2 57,000 89,000
3 5,000 94,000
4 28,000 122,000
5 16,000 138,000
6 3,000 141,000
7 85,000 226,000
$150,000 – $141,000 = $9,000/$85,000 = .11
d. The project is quantitatively unacceptable because it has a negative NPV, a less-
than-one PI, and a payback period of over six years. However, the NPV and PI
are extremely close to being acceptable. Because the new machine will provide
XYZ zero-defect production, the investment may be desirable if additional
qualitative factors are considered such as improved competitive position,
customer satisfaction, goodwill generated, improved product quality and
reliability, and a desire to be in the forefront of manufacturing capability. XYZ
may want to attempt to quantify these benefits and reevaluate the machine’s
acceptability as an investment.
DIFFICULT
17. (Present value tables needed to answer this question.) The Ruth Company has been
operating a small lunch counter for the convenience of employees. The counter occupies
space that is not needed for any other business purpose. The lunch counter has been
managed by a part-time employee whose annual salary is $3,000. Yearly operations have
consistently shown a loss as follows:
Receipts $20,000
Expenses for food, supplies (in cash) $19,000
Salary 3,000 22,000
Net Loss $(2,000)
A company has offered to sell Ruth automatic vending machines for a total cost of
$12,000. Sales terms are cash on delivery. The old equipment has zero disposal value.
The predicted useful life of the equipment is 10 years, with zero scrap value. The
equipment will easily serve the same volume that the lunch counter handled. Z catering
company will completely service and supply the machines. Prices and variety of food
and drink will be the same as those that prevailed at the lunch counter. The catering
company will pay 5 percent of gross receipts to the Ruth Company and will bear all costs
of food, repairs, and so forth. The part-time employee will be discharged. Thus, Ruth’s
only cost will be the initial outlay for the machines.
Consider only the two alternatives mentioned.
Required:
a. What is the annual income difference between alternatives?
b. Compute the payback period.
c. Compute:
1. The net present value if relevant cost of capital is 20 percent.
2. Internal rate of return.
d. Management is very uncertain about the prospective revenue from the vending
equipment. Suppose that the gross receipts amounted to $14,000 instead of
$20,000. Repeat the computation in part c.1.
e. What would be the minimum amount of annual gross receipts from the vending
equipment that would justify making the investment? Show computations.
ANSWER:
a. Old loss $(2,000)
New receipts $20,000 × 5% = $ 1,000
Depr. $12,000/10 yrs. = (1,200)
New (Loss) $ (200)
b. Change in annual cash inflow is $3,000
Payback = $12,000/$3,000 = 4 yrs.
c. 1. PV of inflow $3,000 × 4.1925 = $12,577.50
PV of outflow $12,000 × 1.0 = (12,000.00 )
NPV $ 577.50
2. IRR is approximately 23%
d. Change in inflow = $2,700
PV inflow $2,700 × 4.1925 = $11,319.75
PV outflow $12,000 × 1.0 = (12,000.00)
NPV $ (680.25 )
e. $12,000/4.1925 = $2,862.25
Receipts = ($2,862.25 – $2,000)/.05 = $17,245
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18. The Sun Corp. is contemplating the acquisition of an automatic car wash. The following
information is relevant:
The cost of the car wash is $160,000
The anticipated revenue from the car wash is $100,000 per annum.
The useful life of the car wash is 10 years.
Annual operating costs are expected to be:
Salaries $30,000
Utilities 9,600
Water usage 4,400
Supplies 6,000
Repairs/maintenance 10,000
The firm uses straight-line depreciation.
The salvage value for the car wash is zero.
The company’s cutoff points are as follows:
Payback 3 years
Accounting rate of return 18%
Internal rate of return 18%
Ignore income taxes.
Required:
a. Compute the annual cash inflow.
b. Compute the net present value.
c. Compute internal rate of return.
d. Compute the payback period.
e. Compute the profitability index.
f. Should the car wash be purchased?
ANSWER:
a. Revenue $100,000
– cash expenses (60,000 )
Annual inflow $ 40,000
b. PV inflow $40,000 × 4.4941 = $179,764
PV outflow $160,000 × 1.0 = (160,000 )
NPV = $ 19,764
c. IRR factor = $160,000/$40,000 = 4.0 which is approximately 23%
d. Payback = $160,000/$40,000 = 4 yrs.
e. $179,764/$160,000 = 1.123525
f. Car wash exceeds minimum on SRR and IRR, but not payback.
Looks good to me.
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