Chapter 15 55

Chapter 15

Capital Budgeting

Questions

1. Capital assets are the long-lived assets that are acquired by a firm. Capital assets
provide the essential production and distributional capabilities required by all
organizations.

2. Cash flows are the final objective of capital budgeting investments just as cash flows
are the final objective of any investment. Accounting income ultimately becomes cash
flow but is reported based on accruals and other accounting assumptions and
conventions. These accounting practices and assumptions detract from the purity of
cash flows and, therefore, are not used in capital budgeting.
3. Time lines provide clear visual models of the expected cash inflows and outflows for
each point in time for a project. They provide an efficient and effective means to
help organize the information needed to perform capital budgeting analyses.
4. The payback method measures the time expected for the firm to recover its
investment. The method ignores the receipts expected to occur after the investment
is recovered and ignores the time value of money.

5. Return of capital means the investor is receiving the principal that was originally
invested. Return on capital means the investor is receiving an amount earned on
the investment.
6. The NPV of a project is the present value of all cash inflows less the present values of
all outflows associated with a project. If the NPV is zero, it is acceptable because, in
that case, the project will exactly earn the required cost of capital rate of return. Also,
when NPV equals zero, the project’s internal rate of return equals the cost of capital.
7. It is highly unlikely that the estimated NPV will exactly equal the actual NPV
achieved because of the number of estimates necessary in the original computation.
These estimates include the project life, the discount rate chosen and the timing
and amounts of cash inflows and outflows. The original investment may also include
an estimate of the amount of working capital that is needed at the beginning of the
project life.
8. The NPV method subtracts the initial investment from the discounted net cash
inflows to arrive at the net present value. The profitability index is calculated by
dividing the discounted cash inflows by the initial investment. Thus, each
computation uses the same set of amounts in different ways. The PI model attempts
to measure the planned efficiency of the use of the money (i.e., output/input) in that
it reflects the expected dollars of discounted cash inflows per dollar of investment in
the project. A PI equal to or greater than 1.00 is equivalent to a NPV equal to or
greater than zero and indicates that the investment will provide an acceptable return

55
56 Chapter 15

on capital.
9. The IRR is the rate that would cause the NPV of a project to equal zero. A project is
considered potentially successful (all other factors being acceptable) if the
calculated IRR equals or exceeds the company's cost of capital.
10. The amount of depreciation for a year is one factor that helps determine the amount of
cash outflow for income taxes. Therefore, although depreciation is not a cash flow item
itself, it does affect the size of another item (income taxes) that is a cash flow.
11. The four questions are:
1. Is the activity worthy of an investment?
2. Which assets can be used for the activity?
3. Of the assets available for each activity, which is the best investment?
4. Of the best investments for all worthwhile activities, in which ones should the
company invest?
12. Risk is defined as the likely variability of the future returns of an asset.
Aspects of a project for which risk is involved are:
 Life of the asset
 Amount of cash flows
 Timing of cash flows
 Salvage value of the asset
 Tax rates
When risk is considered in capital budgeting analysis, the NPV of a project is
lowered.

13. Sensitivity analysis is used to determine the limits of value for input variables (e.g.,
discount rate, cash flows, asset life, etc.) beyond which the project's outcome will be
significantly affected. This process gives the decision maker an indication of how
much room there is for error in estimates for input variables and which input
variables need special attention.

14. Post-investment audits are performed to determine whether the realized return
matches the expected return on a project. Post-investment audits are performed at
or near the end of a project’s life.

15. The time value of money refers to the concept that money has time-based earnings
power. Money can be loaned or invested to earn an expected rate of return.
Present value is always less than future value because of the time value of money.
A future value must be discounted to determine its equivalent (but smaller) present
value. The discounting process strips away the imputed rate of return in future
values, thus resulting in smaller present values.

16. ARR = Average annual profits ÷ Average investment

Unlike the rate used to discount cash flows or to compare to the cost of capital rate,
the ARR is not a discount rate to apply to cash flows. It is measured from accrual-
based accounting information and is not intended to be associated with cash flows.
 Exercises

17. Investors are ultimately most interested in cash flows. Investors can’t spend
accounting earnings, they can only spend the cash that is ultimately derived
from their investment in the firm. Investors are interested in accounting
earnings because the earnings reveal information about present and future
cash flows that isn’t revealed in examining only cash flows. Hence,
accounting earnings are only useful to investors if they inform the investors
about cash flows.

18. Cash flows

Period: 0 1 2 3 4 5
-1,000,000 325,000 325,000 325,000 325,000 325,000

Accounting earnings
Period: 0 1 2 3 4 5
Expense savings 325,000 325,000 325,000 325,000 325,000
Depreciation -200,000 -200,000 -200,000 -200,000
-200,000

19. No solution provided.

20. The main point made in the report should be that stock prices are expected
future cash flows of the firm discounted at an appropriate risk-adjusted
discount rate. The risk-adjusted discount rate is a function of both the
riskiness of the specific security and the prevailing market rates of interest. As
the prevailing market interest rates change, the value of securities change
also…especially those that have distant future cash flows that comprise a
significant portion of the value of the security, e.g., growth stocks.

21. a. Payback = $750,000 ÷ $150,000 per year = 5.00 years

b. Year Amount Cumulative Amount
 1 $ 75,000 $ 75,000
2 75,000 150,000
3 75,000 225,000
4 75,000 300,000
5 75,000 375,000
6 100,000 475,000
7 100,000 575,000
8 100,000 675,000
9 100,000 775,000
10 100,000 875,000
The payback is 8 years plus (750,000 – 675,000)/100,000 = 8.75 years.
22. a. Year Amount Cumulative Amount
1 $70,000 $ 70,000
2 78,000 148,000
3 72,000 220,000
4 56,000 276,000
5 50,000 326,000
6 48,000 374,000
7 44,000 418,000

Payback = 5 years + ($14,000 ÷ $48,000) = 5.29 years

Based on the payback criterion, Parkwood should not invest in the

proposed product line.

b. Yes. Parkwood should also use a discounted cash flow technique for two
reasons: (1) to take into account the time value of money and (2) to
consider those cash flows that occur after the payback period.

23. Point in Time Cash Flows PV Factor Present Value

0 $(1,600,000) 1.0000 $(1,600,000)
   1 280,000 0.8929 250,012
2 280,000 0.7972 223,216
3 340,000 0.7118 242,012
4 340,000 0.6355 216,070
5 340,000 0.5674 192,916
6 288,800 0.5066 146,306
7 288,800 0.4524 130,653
8 288,800 0.4039 116,646
9 260,000 0.3606 93,756
10 260,000 0.3220 83,720
NPV $ 95,307

Based on the NPV, this is an acceptable investment.

24. a. The contribution margin of each part is $2 ($15 - $13)

Contribution margin per year = $2 x 50,000 = $100,000

Point in Time Cash Flows PV Factor Present Value

0 $ (500,000) 1.0000 $ (500,000)
     1 - 8 (20,000) 5.5348 (110,696)
1- 8 100,000 5.5348 553,480
NPV $ (57,216)

b. Based on the NPV, this is not an acceptable investment.

 c. Other considerations would include whether refusing to produce this part
for the customer would cause a loss of other business from the customer.
The company should also consider going back to the customer and asking
for a higher price that would cause the project to have a positive NPV.

25. PI = PV of cash inflows ÷ PV of cash outflows

= ($6,000 + $60,000) ÷ $60,000 = 1.10

26. a. PV of inflows: $571,175 ($89,000 x 6.4177)

PV of investment: $600,000
PI = $571,175 ÷ $600,000 = 0.95
b. Miami tours should not add the bus route because the PI is less than
1.00.
c. To be acceptable, a project must generate a PI of at least 1; a PI
greater than 1 equates to an NPV > 0.

27. a. PV = discount factor x annual cash inflow

$680,000 = discount factor x $144,000
Discount factor = $680,000 ÷ $144,000 = 4.7222
The IRR is 13% rounded to the nearest whole percent.
b. Yes. The IRR on this proposal is greater than the firm's hurdle rate of 7%.
c. $680,000 = 5.9713 x Annual cash flow
Annual cash flow = $680,000 ÷ 5.9713
Annual cash flow = $113,878

28. a. PV = discount factor x annual cash inflow

$1,800,000 = discount factor x $300,000
Discount factor = $1,800,000 ÷ $300,000 = 6.0000
The IRR is 10.5% rounded to the nearest half percent.

The project is unacceptable because the IRR is less than the discount rate.
b. The main qualitative factors would be the effect of the technology on the
perceived quality of the food that is processed by the new machinery. An
additional consideration would be the effect of the technology on
employees, particularly if the acquisition would cause layoffs.

29. Investment cost = $250,000 × discount factor for 14%, 7 years

= $250,000 × 4.2883 = $1,072,075
NPV = $250,000 × discount factor (10%, 7 years) - $1,072,075
= $1,217,100 - $1,072,075 = $145,025

30. a. Straight-line method

Annual depreciation = $2,000,000 ÷ 8 years = $250,000 per year
Tax benefit = $250,000 x 0.30 = $75,000
PV = $75,000 x 5.7466 = $430,995
b. Accelerated method
$2,000,000 x 0.30 x 0.40 x .9259 = $222,216
$1,200,000 x 0.30 x 0.40 x .8573 = 123,451
 $ 720,000 x 0.30 x 0.40 x .7938 = 68,584
$ 432,000 x 0.30 x 0.40 x .7350 = 38,102
$ 259,200* x 0.30 x .6806 = 52,923
Total $505,276
*
In the final year, the remaining undepreciated cost is expensed.

c. The depreciation benefit computed in part (b) exceeds that computed in

part (a) solely because of the time value of money. The depreciation
method in part (b) allows for faster recapture of the cost; therefore, there is
less discounting of the future cash flows.

31. a. SLD = $30,000,000 ÷ 8 years = $3,750,000 per year

     Before-tax CF $6,200,000

Less depreciation 3,750,000
Before-tax NI 2,450,000
Less tax (30%) 735,000
NI 1,715,000
Add depreciation 3,750,000
After-tax CF $5,465,000
Point in Time Cash Flows PV Factor Present Value
0 $(30,000,000) 1.0000 $(30,000,000)
  1 - 8 5,465,000 6.2098 33,936,557
NPV $ 3,936,557

The project is acceptable.

b. Years 1 and 2 Years 3-8

Before-tax CF $ 6,200,000 $6,200,000
Less Depreciation 6,900,000 2,700,000
Before-tax NI (700,000) 3,500,000
Tax (tax benefit) (210,000) 1,050,000
After-tax NI (490,000) 2,450,000
Add Depreciation 6,900,000 2,700,000
After-tax CF $ 6,410,000 $5,150,000
Point in Time Cash Flows PV Factor Present Value
0 $(30,000,000) 1.0000 $(30,000,000)
1- 2 6,410,000 1.8334 11,752,094
3- 8 5,150,000 4.3764 22,538,460
NPV $ 4,290,554

The project is acceptable.

c. Recomputation of part (a):
Before-tax CF $6,200,000
Less depreciation 3,750,000
NIBT 2,450,000
Less tax (40%) 980,000
NI 1,470,000
Add depreciation 3,750,000
After-tax CF $5,220,000
 Point in Time Cash Flows PV Factor Present Value
0 $(30,000,000) 1.0000 $(30,000,000)
1- 8 5,220,000 6.2098 32,415,156
NPV $ 2,415,156

The project is acceptable.

Recomputation of part (b):
Years 1 and 2 Years 3-8
Before-tax CF $ 6,200,000 $6,200,000
Less Depreciation 6,900,000 2,700,000
NIBT $ (700,000) $3,500,000
Less Tax(tax benefit) (280,000) 1,400,000
After-tax NI $ (420,000) $2,100,000
Add Depreciation 6,900,000 2,700,000
After-tax CF $ 6,480,000 $4,800,000
Point in Time Cash Flows PV Factor Present Value
0 $(30,000,000) 1.0000 $(30,000,000)
1- 2 6,480,000 1.8334 11,880,432
3- 8 4,800,000 4.3764 21,006,720
NPV $ 2,887,152

The project is acceptable.

32. a. Tax: $190,000 - $36,000 = $154,000

Financial accounting: $190,000 - $70,000 = $120,000

b. CFAT = Market value now minus taxes

= $74,000 - (($74,000 - $36,000) x .30) = $62,600

c. CFAT = $18,000 - (($18,000 - $36,000) x .30) = $23,400

33. a. payback
b. NPV, PI
c. IRR
d. payback, NPV, PI, IRR
e. all methods
f. payback
g. ARR

34. a. payback, NPV, PI, IRR

b. payback
c. ARR
d. payback, IRR
e. payback, NPV, PI, IRR
f. payback, NPV, PI, IRR
g. IRR
h. payback, IRR, ARR

35. a. Project Name NPV PI IRR

 Film studios $3,578,910 1.18 13.03%
Cameras & equipment 1,067,920 1.33 18.62
Land improvement 2,250,628 1.45 19.69
Motion picture #1 1,040,276 1.06 12.26
Motion picture #2 1,026,008 1.09 14.22
Motion picture #3 3,197,320 1.40 21.34
Corporate aircraft 518,916 1.22 18.15
b. Ranking according to:
NPV PI IRR
1. Film Studios Land improvement MP #3
2. MP #3 MP#3 Land Improvement
3. Land Improvement Camera & Equip. Camera & Equip.
4. Camera & Equip. Corp. Aircraft Corp. Aircraft
5. MP #1 Film Studio MP #2
6. MP #2 MP #2 Film Studios
7. Corp. Aircraft MP #1 MP #1

c. Suggested purchases: NPV

1. MP #3 @ $8,000,000 $3,197,320
2. Land improvemten @ $5,000,000 2,250,628
3. Cam. & Equip. @ $3,200,000 1,067,920
4. Corp. Aircraft @ $2,400,000 518,916
Total NPV $7,034,784

36. a. Cash flow x annuity factor = $120,000

Cash flow x 3.6048 = $120,000
Cash flow = $33,289

b. $120,000 ÷ $33,289 = 3.60 years

37. a. NPV = ($14,000 × 4.5638) - $50,000 = $13,893

b. annuity factor × $14,000 = $50,000

annuity factor = $50,000 ÷ $14,000 = 3.5714
This factor corresponds most closely to 20%

38. PV = FV × discount factor

$30,000 = FV × .7473
FV = $30,000 ÷ .7473 = $40,145

39. Cost = $8,000 + PV($800 annuity) = $8,000 + ($800 x 44.955 *) = $43,964

*
discount factor for 60 months, 1%

40. a. PV = future value x discount factor

= $60,000 x .6663
= $39,978 should be invested to achieve the goal

b. PV = future value x discount factor

= $300,000 x .3769
= $113,070 would be equivalent today
 c. PV = future value x discount factor
= $60,000 x .2146
= $12,876
d. Present value = annuity x annuity discount factor
= $100,000 x 3.9927
= $399,270

e. Year 1 receipt: $ 50,000 x .9346 = $ 46,730

Year 2 receipt: $ 55,000 x .8734 = 48,037
Year 3 receipt: $ 60,000 x .8163 = 48,978
Year 4 receipt: $100,000 x .7629 = 76,290
Year 5 receipt: $100,000 x .7130 = 71,300
Year 6 receipt: $100,000 x .6663 = 66,630
Year 7 receipt: $100,000 x .6228 = 62,280
Year 8 receipt: $100,000 x .5820 = 58,200
Year 9 receipt: $ 70,000 x .5439 = 38,073
Year 10 receipt: $ 45,000 x .5084 = 22,878
Present value $539,396

f. No. Using any discount rate above 0, the present value of the future annual
cash flows is well below $1,000,000. Only if the friend has substantial
other assets would she be a millionaire.

41. a. Change in net income = $10,000,000 - ($36,000,000 ÷ 5) = $2,800,000

ARR = $2,800,000 ÷ ($36,000,000 ÷ 2) = 15.56%
Payback = $36,000,000 ÷ $10,000,000 per year = 3.6 years
b. No. Although the dredge meets the payback criterion, it fails to meet the
ARR criterion of 18%.

42. a. Annual cash receipts $ 7,000

Cash expenses (1,000)
Net cash flow before taxes $ 6,000
Depreciation (3333)
Income before tax $2,667
Taxes (800)
Net income $1,867
Depreciation 3,333
Annual after-tax cash flow $5,200

b. Payback = $20,000 ÷ $5,200 per year = 3.85 years

c. ARR = $1,867 ÷ ($20,000 ÷ 2) = 18.67%

Problems

43. a. A lease is often found appealing by consumers because it results in a

lower monthly payment in many instances than the monthly payment that is
required to purchase a car. This allows the consumer either to enjoy a
 lower monthly payment or, for the same monthly payment required to
amortize the cost of one vehicle, pay a similar monthly amount for a more
expensive car.

b. No. A consumer should be provided with all necessary information to

make a fair comparison between the lease and purchase alternative.

c. As an accountant, you could provide a financial comparison of the lease

and purchase alternatives. Using a discounted cash flow approach, you
could compare the present value of purchasing the vehicle to the present
value of leasing the vehicle.

44. a. Although the 12% hurdle rate may be appropriate for most projects, it may
be inappropriate to insist that a project such as a pollution abatement
project be required to meet any financial hurdle rate.

b. In the future, the company could face not only significant fines from
government regulators, but also financial claims filed by persons harmed
by the arsenic.

c. Myers should justify the investment based both on the potential future
financial claims and that it is the socially and ethically correct action for
the company to take.

45. a. ($000s omitted)

t0 t1 t2 t3 t4 t5 t6 t7 t8
Investment -380
New CM 120 120 120 120 120 120 120 120
Oper. costs 0 -40 -54 -54 -54 -60 -60 -60 -66
Cash flow -380 80 66 66 66 60 60 60 54

b. Year Cash Flow Cumulative Cash Flow

1 $80,000 $ 80,000
2 66,000 146,000
3 66,000 212,000
4 66,000 278,000
5 60,000 338,000
6 60,000 398,000

     Payback = 5 + (($380,000 - $338,000) ÷ $60,000) = 5.7 years

c. Time Cash Flow PV Factor for 8% Present Value

0 $(380,000) 1.0000 $(380,000)
1 80,000 .9259 74,072
2 66,000 .8573 56,582
3 66,000 .7938 52,391
4 66,000 .7350 48,510
5 60,000 .6806 40,836
6 60,000 .6302 37,812
7 60,000 .5835 35,010
8 54,000 .5403 29,176
NPV $ (5,611)
46. a. Time: t0 t1 t2 t3 t4 t5 t6 t7
Amount: ($41,000) $7,900 $8,100 $8,300 $8,000 $8,000 $8,300 $9,200

b. Year Cash Flow Cumulative

Year 1 $7,900 $ 7,900
Year 2 8,100 16,000
Year 3 8,300 24,300
Year 4 8,000 32,300
Year 5 8,000 40,300

Payback = 5 years + (($41,000 - $40,300) ÷ $8,300) = 5.08 years

c. Cash Flow Discount Present

Description Time Amount Factor Value
Purchase the truck t0 $(41,000) 1.0000 $(41,000)
Cost savings t1 7,900 .9091 7,182
Cost savings t2 8,100 .8265 6,695
Cost savings t3 8,300 .7513 6,236
Cost savings t4 8,000 .6830 5,464
Cost savings t5 8,000 .6209 4,967
Cost savings t6 8,300 .5645 4,685
Cost savings t7 9,200 .5132 4,721
NPV $ (1,050)

47. a. Year Cash Flow PV Factor PV

0 $(10,000,000) 1.0000 $(10,000,000)
1- 7 1,676,000 5.3893 9,032,467
7 800,000 .6228 498,240
NPV $ (469,293)

b. No, the NPV is negative; therefore this is an unacceptable project.

c. PI = ($9,032,467 + $498,240) ÷ $10,000,000 = 0.95

d. PV of annual cash flows = $10,000,000 - $498,240

PV of annual cash flows = $9,501,760

PV of annual Cash flows = Annual cash flow x 5.3893

$9,501,760 = Annual cash flow x 5.3893
Annual cash flow = $9,501,760 ÷ 5.3893 = $1,763,079

Minimum labor savings = $1,763,079 + operating costs

= $1,763,079 + $224,000
=$1,987,079 

e. The company should consider the quality of the work performed by the
machine versus the quality of the work performed by the individuals; the
reliability of the manual process versus the reliability of the mechanical
process; and perhaps most importantly, the effect on worker morale and
the ethical considerations in displacing 14 workers.
48. a. Payback period = $120,000 ÷ ($52,500 - $8,500) = 2.73 years
The project does meet the payback criterion.

b. Discount factor = Investment ÷ annual cash flow

= $120,000 ÷ $44,000 = 2.7273
Discount factor of 2.7273 indicates IRR ≈ 17 %
This is an acceptable IRR.

c. Dorak should consider two main factors. First, the effect of the computer
system on the accuracy of tax returns and the quality of service delivered to
clients. Second, Dorak should consider the effect of firing one employee on
both the dismissed employee and the remaining employees.

49. a. The incremental cost of the new machine: $580,000 - $12,000 = $568,000

Cash Flow Discount Present

Description Time Amount Factor Value
Incremental cost t0 $(568,000) 1.0000 $ (568,000)
Cost savings t1 - t8 120,000 5.1461 617,532
NPV $ 49,532

PI = $617,532 ÷ $568,000 = 1.09

Yes, the machine should be purchased because the NPV > 0 and the PI > 1.

b. Payback = $568,000 ÷ 120,000 per year = 4.73 years

c. Net investment ÷ annual annuity = discount factor of IRR

$568,000 ÷ 120,000 = 4.7333
Discount factor of 4.7333 is between 13.0 and 13.5%; therefore, to the
nearest whole percent, the IRR is 13%.

50. a. Computation of net annual cash flow:

Increase in revenues $ 43,500
Increase in cash expenses (18,500)
Increase in pretax cash flow 25,000
Less Depreciation (9,750)
Income before tax 15,250
Income taxes (30 percent) (4,575)
Net income 10,675
Add Depreciation 9,750
After-tax cash flow $ 20,425

                          Cash Flow Discount Present

Description Time Amount Factor Value
Initial cost t0 $(195,000) 1.0000 $(195,000)
Annual cash flow t1- t20 20,425 9.1286 186,452
NPV $ (8,548)

b. No, this is not an acceptable investment. The net present value is not
 close to the cutoff value of $0.

c. Minimum annual after tax cash flow x discount factor = $195,000

Minimum annual after tax cash flow x 9.1286 = $195,000
Minimum annual after tax cash flow = $21,361

$21,361 = (minimum cash revenues - $18,500 -9,750)(1 – tax rate) +$9,750

$11,611 = (minimum cash revenues - $18,500 -9,750)(1- .30)
$16,587 = minimum cash revenues - $28,250
Minimum cash revenues = $44,837
Proof:
Computation of net annual cash flow:
Increase in revenues $ 44,837
Increase in cash expenses (18,500)
Increase in pretax cash flow $26,337
Less Depreciation (9,750)
Income before tax $16,587
Income taxes (30 percent) (4,976)
Net income $11,611
Add Depreciation 9,750
After-tax cash flow $ 21,361

51. a. Cash flow after tax (CFAT):

Year Pretax CF Depreciation Tax CFAT
1 $104,000 $ 64,000 $14,000 $ 90,000
2 118,000 102,400 5,460 112,540
3 118,000 60,800 20,020 97,980
4 102,000 48,000 18,900 83,100
5 86,000 44,800 14,420 71,580

Timeline:
         t0 t1 t2 t3 t4 t5
$(320,000) $90,000 $112,540 $97,980 $83,100 $71,580

  b. Year Net Cash Flow Cumulative Cash Flow

1 $ 90,000 $ 90,000
2 112,540 202,540
3 97,980 300,520
4 83,100 383,620
        Payback = 3 years + (($320,000 – 300,520) ÷ $83,100) = 3.23 years.

Net present value:

Time Amount Discount Factor Present Value
Year 0 $(320,000) 1.0000 $(320,000)
Year 1 90,000 .9346 84,114
Year 2 112,540 .8734 98,292
Year 3 97,980 .8163 79,981
Year 4 83,100 .7629 63,397
Year 5 71,580 .7130 51,037
NPV $ 56,821
 Profitability index = ($320,000 + $56,821) ÷ $320,000 = 1.18

IRR is 14%.

52. a. Maple Commercial Plaza:

t0 t1 - t10 t10
$(800,000) $210,000 $400,000

High Tower:
t0 t1 - t10 t10
$(3,400,000) $830,000 $1,500,000

b. Maple Commercial Plaza:

Calculation of annual cash flow:
Pretax cost savings $210,000
Depreciation ($800,000 ÷ 25) (32,000)
Pretax income 178,000
Taxes (40 percent) (71,200)
Aftertax income 106,800
Depreciation 32,000
Aftertax cash flow $138,800

t0 t1 - t10 t10
$(800,000) $138,800 $432,000 *
*
Includes $32,000 from tax loss on sale (0.40  ($400,000 - $480,000))

High Tower:
Calculation of annual cash flow:
Pretax cost savings $ 830,000
Depreciation ($3,400,000 ÷ 25) (136,000)
Pretax income 694,000
Taxes (277,600)
Aftertax income 416,400
Depreciation 136,000
Aftertax cash flow $ 552,400

t0 t1 - t10 t10
$(3,400,000) $552,400 $1,716,000 *
*
Includes $216,000 from tax loss on sale (0.40  ($1,500,000 - $2,040,000))

c. After-tax NPV, Maple Commercial Plaza:

Amount Discount Factor Present Value
Year 0 $(800,000) 1.0000 $(800,000)
Year 1-10 138,800 5.8892 817,421
Year 10 432,000 .3522 152,150
NPV $ 169,571

After-tax NPV, Hightower:

Amount Discount Factor Present Value
Year 0 $(3,400,000) 1.0000 $(3,400,000)
 Year 1-10 552,400 5.8892 3,253,194
Year 10 1,716,000 .3522 604,375
NPV $ 457,569
Based on the NPV criterion, Hightower is the preferred investment.

d. After-tax NPV, Hightower:

Amount Discount factor Present Value
Year 0 $(3,400,000) 1.0000 $(3,400,000)
Year 1-10 180,400 5.8892 1,062,412
*
Year 1-10 372,000 4.1925 1,559,610
Year 10 1,716,000 .3522 604,375
NPV $ (173,603)
*
Rental portion of cash flow = $620,000  (1 - tax rate)
= $620,000  0.60
= $372,000

In this circumstance, Maple Commercial Plaza is the preferred investment.

53. a. Depreciation per year = $1,500,000 ÷ 14 = $107,143

Before tax cash flows = [300 x 0.80 x ($60 - $10) x 50] - $250,000
= $350,000 per year
Before-tax CF $350,000
Less Depreciation (107,143)
Income before tax 242,857
Less tax (25%) (60,714)
Net income 182,143
Add Depreciation 107,143
After-tax cash flow $289,286

PV of 14 yr. annuity of $289,286 @ 11% $2,019,765

Less cost (1,500,000)
NPV $ 519,765
b. Discount factor = $1,500,000 ÷ $289,286 = 5.1852
Discount factor of 5.1852 corresponds to ≈ 17%.
c. Cash flow x discount factor = $1,500,000
Cash flow x (6.9819) = $1,500,000
Cash flow = $214,841

d. $1,500,000 ÷ $289,286 = 5.1852

5.1852 is the discount factor for 11% and falls between the 11% discount
factors corresponding to 8 and 9 years. 

54. a. Incremental annual after-tax cash flows:

Purchase Year 0
Purchase of new equipment $(300,000)
One time production expense net of tax ($30,000 x .6) (18,000)
Sale of old equipment net of tax ($5,000 x .6) 3,000
Total initial cash outflow $(315,000)
 Annual Operations

Year 1 Year 2 Year 3 Year 4

Cash operating
savings $ 90,000 $150,000 $150,000 $150,000
Less tax effect (40%) (36,000) (60,000) (60,000) (60,000)
Cash savings after-tax 54,000 90,000 90,000 90,000
Depr. tax shield
(see sched. below) 48,000 36,000 24,000 12,000
After-tax operating
cash flows $102,000 $126,000 $114,000 $102,000

Depreciation Schedule
Depreciable Base: $300,000
Life: Four-Year Limit
Method: Sum-of-the-Years'-Digits
Year Rate Depreciation Depr. Shield
1 4/10 $120,000 $48,000
2 3/10 90,000 36,000
3 2/10 60,000 24,000
4 1/10 30,000 12,000

b. The company should accept the proposal since the NPV is positive.
Year Cash Flow 12% PV Factor PV
0 $(315,000) 1.0000 $(315,000)
1 102,000 .8929 91,076
2 126,000 .7972 100,447
3 114,000 .7118 81,145
4 102,000 .6355 64,821
NPV $ 22,489
                                                              (CMA)

55. a. The benefits of a postcompletion audit program for capital expenditure

projects include these:
 The comparison of actual results with projected results to validate
that a project is meeting expected performance or to take corrective
action or terminate a project not achieving expected performance.
 An evaluation of the accuracy of projections from different
departments.
 The improvement of future capital project revenue and cost
estimates through analyzing variations between expected and actual
results from previous projects and the motivational effect on
personnel arising from the knowledge that a postinvestment audit
will be done.
 b. Practical difficulties that would be encountered in collecting and
accumulating information include:
 Isolating the incremental changes caused by one capital project from
all the other factors that change in a dynamic manufacturing and/or
marketing environment.
 Identifying the impact of inflation on all costs in the capital project
justification.
 Updating of the original proposal for approval of changes that may
have occurred after the initial approval.
 Having a sufficiently sophisticated information accumulation system
to measure actual costs incurred by the capital project.
 Allocating sufficient administrative time and expenses for the
postcompletion audit.
                                                       (CMA adapted)

56. a. Year Revenue VC FC Net Cash Flow

1-4 $125,000 $ 75,000 $20,000 $ 30,000
5-8 175,000 105,000 20,000 50,000
9 - 10 100,000 60,000 20,000 20,000

Year Cash Flow PV Factor PV

0 $(145,000) 1.0000 $(145,000)
1–4 30,000 3.1699 95,097
5-8 50,000 2.1651 108,255
9 – 10 20,000 .8096 16,192
10 10,000 .3855 3,855
NPV $ 78,399

b. Year Revenue VC FC Net Cash Flow

1-4 $120,000 $ 78,000 $15,000 $27,000
5-8 200,000 130,000 17,500 52,500
9 - 10 103,000 66,950 25,000 11,050

Year Cash Flow PV Factor PV

0 $(137,500) 1.0000 $(137,500)
1–4 27,000 3.1699 85,587
5–8 52,500 2.1651 113,668
9 – 10 11,050 .8096 8,946
10 23,500 .3855 9,059
NPV $ 79,760

c. The biggest factors are the increased level of variable costs, the additional
working capital, the lower initial revenues, and the lower cost of production
equipment.

57. a. Cash Cash Net Cumulative

Year Receipts Expenses Inflows Cash Flows
1 $3,000,000 $2,530,000 $ 470,000 $ 470,000
2 3,200,000 2,400,000 800,000 1,270,000
3 3,720,000 2,582,000 1,138,000 2,408,000
4 5,120,000 3,232,000 1,888,000 4,296,000
 5 6,400,000 3,520,000 2,880,000 7,176,000

Payback = 4 + (($6,400,000 - $4,296,000) ÷ $2,880,000) = 4.73 years

b. Year Cash Flow PV Factor PV

0 $(6,400,000) 1.0000 $(6,400,000)
1 470,000 .9174 431,178
2 800,000 .8417 673,360
3 1,138,000 .7722 878,764
4 1,888,000 .7084 1,337,459
5 2,880,000 .6499 1,871,712
6 2,880,000 .5963 1,717,344
7 1,632,000 .5470 892,704
8 648,000 .5019 325,231
NPV $ 1,727,752

c. Year Net Income

1 $ (330,000)
2 0
3 338,000
4 1,088,000
5 2,080,000
6 2,080,000
7 832,000
8 (152,000)
$5,936,000

Average annual income = $5,936,000 ÷ 8 = $742,000

Average Investment = (Cost + Salvage) ÷ 2
= ($6,400,000 + $0) ÷ 2 = $3,200,000
ARR = $742,000 ÷ $3,200,000 = 23.19%

d. Although there are no stated evaluation criteria for accounting rate of

return or payback, the NPV criterion meets the standard threshold of $0.
Therefore, the product line should be added.

58. a. Initial cost: t0 = $(1,460,000) + $340,000 = $(1,120,000)

Annual cash flow:
Additional revenue ($1.20 x 220,000) $264,000
Labor savings 60,000
Other operating savings ($192,000 - $80,000) 112,000
Total $436,000

NPV = $(1,120,000) + ($436,000 x 6.1446) = $1,559,046

b. Discount factor = $1,120,000 ÷ $436,000 = 2.5688

The IRR exceeds numbers reported in the present value appendix. By
computer, the IRR is found to be 37%.
c. $1,120,000 ÷ $436,000 = 2.5688 years

d. ARR = ($436,000 - $62,000) ÷ (($1,120,000 + $0) ÷ 2) = 66.79%

e. Because the project generates a very high NPV and IRR, as well as a high
ARR, the firm should buy the new equipment.
(CMA adapted)