CRITICAL THINKING

96. Explain why a corporation's customer base is considered an intangible asset.

Answer:
A corporation's customer base is considered an intangible asset because if it is
handled properly, a corporation's existing customers will be a source of revenues
for an indefinite time period. One could make the case that the customer base is like
an annuity — a steady source of revenues and earnings. Thus it is an asset, although
an intangible one.

An existing customer usually will stay with a corporation if he or she is handled

properly. Usually there is minimal marginal cost in retaining a customer other than
producing a satisfactory product. In contrast, attracting new customers takes time,
effort, and most times substantial marketing dollars. Thus, it is much easier to retain
a current customer than to obtain a new one. This is why the existing customer base
is considered an asset.

Difficulty: 2 Objective: 1
Terms to Learn: capital budgeting

97. Explain capital budgeting, and then briefly discuss each of the six stages of a capital
budgeting project?

Answer:
Capital budgeting is long-run planning for investment projects that usually have a
life that is greater than one year.

Stage 1 of a capital budgeting project is the identification stage, in which a firm

determines which types of capital investments are necessary to accomplish
organization objectives and strategies. Stage 2 is the search stage, in which a firm
explores alternative capital investments that will achieve the firm’s objectives.
Stage 3 is the information-acquisition stage in which a firm considers the expected
costs and benefits of alternative capital investments. Stage 4 is the selection stage,
in which a firm chooses projects for implementation. Stage 5 is the financing stage
in which a firm obtains project funding. Stage 6 is the implementation and control
stage in which a firm starts the projects and monitors their performance

Difficulty: 2 Objectives: 2
Terms to Learn: capital budgeting

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98. Cast Iron Stove Company wants to buy a molding machine that can be integrated
into its computerized manufacturing process. It has received three bids for the
machine and related manufacturer's specifications. The bids range from $3,500,000
to $3,550,000. The estimated annual savings of the machines range from $260,000
to $270,000. The payback periods are almost identical and the net present values are
all within $8,000 of each other. The president just doesn't know what to do about
which vendor to choose since all of the selection criteria are so close together.

Required:
What suggestions do you have for the president?

Answer:
The president needs to consider nonfinancial and qualitative factors between the
three vendors. Quality of output units, manufacturing flexibility, and cycle time are
all additional factors that can be considered about the machines. Other items might
include worker safety, ease of learning and using, and ease of maintenance.

Difficulty: 2 Objective: 2
Terms to Learn: capital budgeting

99. Retail Outlet is looking for a new location near a shopping mall. It is considering
purchasing a building rather than leasing, as it has done in the past. Three retail
buildings near a new mall are available but each has its own advantages and
disadvantages. The owner of the company has completed an analysis of each
location that includes considerations for the time value of money. The information
is as follows:

Location A Location B Location C

Internal rate of return 13% 17% 20%
Net present value $25,000 $40,000 $20,000

The owner does not understand how the location with the highest percentage return
has the lowest net present value.

Required:
Explain to the owner what is (are) the probable cause(s) of the comparable
differences.

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 Answer:
The highest probability is that location C has a much lower initial investment than
the other two. Therefore, it can show a higher rate of return with fewer dollars of
inflow. Unfortunately, this may cause it to have the lowest net present value since
this model is presented in dollar terms. Location C could also have a shorter life
which could give it a higher percentage return during its life but fewer dollars
overall.

Difficulty: 2 Objective: 3
Terms to Learn: net present value (NPV) method

100. What are the four alternative methods for evaluating capital budgeting projects?
What is an advantage and disadvantage of each method?

Answer:
The four methods are: 1. Net Present Value (NPV); 2. Internal Rate of Return
(IRR); 3. Payback; and 4. Accrual Accounting Rate of Return (AARR). NPV has
advantages in that it uses discounted cash flows, and can deal with uneven cash
flows, considers the inflows and outflows of the project. A disadvantage of NPV is
that the results indicate if it achieves a particular cost of capital or not, but it does
not indicate what the rate of return actually is. The IRR method generates an
expected rate of return for the investment given the time of the project and the
discounting of cash flows. A disadvantage of the IRR is that the results are
expressed in the form of a percentage rather than in dollars and it is difficult to use
when the project has uneven cash flows. The payback is simple to use, and adapts to
both even and uneven cash flows. It also highlights the liquidity of a project. A
disadvantage to the payback is that it does not consider either the time value of
money, or the cash flows that occur after the payback time period. The AARR
method uses the information that is most often found in financial statements —
including net income and depreciation. A drawback is that the method does not take
into account the time value of money or the cash flows of the project.

Difficulty: 2 Objectives: 3, 4, 5
Terms to Learn: capital budgeting

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101. Bock Construction Company is considering four proposals for the construction of
new loading facilities that will include the latest in ship loading/unloading
equipment. After careful analysis, the company's accountant has developed the
following information about the four proposals:

Proposal 1 Proposal 2 Proposal 3 Proposal 4

Payback period 4 years 4.5 years 6 years 7 years
Net present value $80,000 $178,000 $166,000 $308,000
Internal rate of return 12% 14% 11% 13%
Accrual accounting rate
8% 6% 4% 7%
of return

Required:
How can this information be used in the decision-making process for the new
loading facilities? Does it cause any confusion?

Answer:
The managers can use the information to determine which proposal is best under the
various alternatives. This may be accomplished by ranking each alternative. Also,
the managers must determine the factors that are the most important to the
company. For example, if short-run risk is high, a short payback period may be
highly desirable. In this case, Proposal 1 is best. However, if total cash returned is
critical to the company's operations, then Proposal 4 is probably best.

Any time that multiple measures are used there may be confusion because very
seldom will one proposal appear to be the best with all models. In this case,
payback ranks Proposal 1 the best, NPV ranks Proposal 4 the best, IRR ranks
Proposal 2 the best, and AARR ranks Proposal 1 the best. The importance of each
ranking will depend upon the circumstances of the organization and the managers
must be attuned as to what is most favorable.

The net present value and the internal rate-of-return methods are superior because
they consider the time value of money.

Difficulty: 2 Objectives: 3, 4, 5
Terms to Learn: payback, net present value (NPV) method, internal rate-of-return
(IRR) method, accrual accounting rate of return (AARR)

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102. What conflicts can arise between using discounted cash flow methods for capital
budgeting decisions and accrual accounting for performance evaluation? How can
these conflicts be reduced?

Answer:
Using accrual accounting to evaluate the performance of a manager may create
conflicts with using discounted cash flow (DCF) methods for capital budgeting
because frequently a project using a DCF method will not report strong operating
income results in the early years of the project under accrual accounting. If this is
the case, a manager might be tempted not to use DCF methods even though the
decisions based on them might be in the best interests of the company over the long
run. The conflict can be reduced by evaluating managers on a project-by-project
basis and by looking at their ability to achieve the amounts and timing of forecasted
cash flows.

Difficulty: 3 Objectives: 6
Terms to Learn: discounted cash flow (DCF) methods, accrual accounting rate of
return (AARR)

103. Explain why the term tax shield is used in conjunction with depreciation.

Answer:
Depreciation tax deductions result in tax savings which offset the cost of acquiring
the capital equipment. The more rapid for tax purposes an asset's costs can be
written off for tax purposes, the earlier the reductions in taxes can be realized. The
term tax shield refers to the reduction in the tax payments owed. Thus the faster the
depreciation, the earlier the reductions in taxes and the greater the net present value
of the tax shield.

Difficulty: 2 Objective: 7
Terms to Learn: capital budgeting

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