PART 2

PART 2 UNIT 5

5
2E. Investment Decisions

Module

1 E.1. Capital Budgeting Process 3

2 E.2. Capital Investment Analysis Methods 13

 NOTES

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1
MODULE
PART 2 UNIT 5

E.1. Capital Budgeting

Process
Part 2
Unit 5

This module covers the following content from the IMA Learning Outcome Statements.

CMA LOS Reference: Part 2—Section E.1. Capital Budgeting Process

The candidate should be able to:

a. define capital budgeting and identify the steps or stages undertaken in developing and
implementing a capital budget for a project
b. identify and calculate the relevant cash flows of a capital investment project on both a
pretax and after-tax basis
c. demonstrate an understanding of how income taxes affect cash flows
d. distinguish between cash flows and accounting profits and discuss the relevance to
capital budgeting of incremental cash flow, sunk cost, and opportunity cost
e. explain the importance of changes in net working capital in capital budgeting
f. discuss how the effects of inflation are reflected in capital budgeting analysis
g. define hurdle rate
h. identify alternative approaches to dealing with risk in capital budgeting
i. distinguish among sensitivity analysis, scenario analysis, and Monte Carlo simulation as
risk analysis techniques
j. explain why a rate specifically adjusted for risk should be used when project cash flows
are more or less risky than is normal for a firm
k. explain how the value of a capital investment is increased if consideration is given to
the possibility of adding on, speeding up, slowing up, or discontinuing early
l. demonstrate an understanding of real options, including the options to abandon,
delay, expand, and scale back (calculations not required)
m. identify and discuss qualitative considerations involved in the capital budgeting decision
n. describe the role of the postaudit in the capital budgeting process

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 1 E.1. Capital Budgeting Process PART 2 UNIT 5

LOS 2E1a 1 Overview of Capital Budgeting

Capital budgeting is a process for evaluating and selecting the long-term investment projects
of the firm. Proper capital budgeting is crucial to the success of an organization. The amount
of cash the company takes in and pays out for an investment affects the amount of cash the
company has available for operations and for other activities of the company. One of the
primary goals of capital budgeting is to implement capital projects that increase the value of the
company to the shareholders (maximize shareholder wealth).

1.1 Stages of Capital Budgeting

Undertaking a capital budget for a project involves five major stages, as follows:
1. Identify and define potential investment opportunities.
2. Estimate the cash inflows and outflows and risk for each potential investment.
3. Analyze the profitability of each potential investment using discounted cash flow methods
and select the investments that maximize profitability.
4. Implement the selected investments.
LOS 2E1n 5. Monitor the investments and conduct a postaudit by comparing actual results to the
estimated results to evaluate the effectiveness and efficiency of each investment. The
postaudit can reveal successful activities and processes as well as non-value-added activities
and processes. Results of the postaudit provides information to improve management's
decision making and implementation strategies for future endeavors.

1.2 Capital Budgeting Principles

The following principles are used in capital budgeting:
  Decision making is based on cash flows, not accounting profits.
  The timing of cash flows is important.
  Cash flows include incremental costs and opportunity costs but exclude sunk costs.
  Cash flows are considered on an after-tax basis.
  Financing costs are considered in the hurdle rate and are not considered a cash outflow.

LOS 2E1b 2 Cash Flows Related to Capital Budgeting

LOS 2E1d
2.1 Relevant Cash Flows
Accounting profits include deductions for depreciation and interest expense. In capital
budgeting, the cost of the investment is considered as a cash outflow at inception, rather than as
a cost depreciated over the life of the asset. The cost of any debt associated with the investment
is included in the hurdle rate used when computing discounted cash flows.

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2.1.1 Incremental Cash Flows

Incremental cash flow is the net increase in operating cash flow during the life of the new capital
investment. A positive incremental cash flow demonstrates that the capital project adds value to
the business by increasing the assets of the company.
Incremental cash flows should include opportunity costs, which are the costs of forgoing the
next best alternative when making a decision. For example, an opportunity cost of replacing an
old machine with a new machine is the cash flow that would have been generated by continuing
to use the old machine.
Incremental cash flows should not include sunk costs. Sunk costs are cost incurred in the past
that cannot be changed by a current investment decision. For example, when considering
whether to replace an old machine with a new machine, the cost of the old machine is a sunk
cost that is not considered when deciding whether to purchase the new machine.

2.2 Cash Flow Effects

2.2.1 Direct Effect
When a company pays out cash, receives cash, or makes a cash commitment that is directly
related to the capital investment, that effect is called the direct effect. It has an immediate effect
on the amount of cash available.

2.2.2 Indirect Effect

Transactions which are indirectly associated with a capital project or which represent noncash
activity that produces cash benefits or obligations are called indirect cash flow effects.

Illustration 1 Cash Flow Effects

Depreciation is a noncash expense taken as a tax deduction. Depreciation reduces

the amount of taxable income and, consequently, the related taxes. The reduced
tax bill resulting from increased depreciation expense associated with a new project
decreases the cash paid out. This type of effect is called an indirect effect (or tax effect) of
capital budgeting.

2.2.3 Net Effect

The total of the direct and indirect effects of cash flows from a capital investment is called the
net effect.

2.3 Stages of Cash Flows

Cash flows exist throughout the life cycle of a capital investment project. Cash flows are
categorized in three general stages.

2.3.1 Inception of the Project (Time Period Zero) LOS 2E1e

Both direct cash flow effects (the acquisition cost of the asset) and indirect cash flow effects
(working capital requirements or disposal of the replaced asset) occur at the time of the initial
investment. The initial cash outlay for the project is often the largest amount of cash outflow
during the project's life.

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1 E.1. Capital Budgeting Process PART 2 UNIT 5

  Working Capital Requirements: Working capital is defined as current assets minus current
liabilities. When a capital project is implemented, the firm may need to increase or decrease
working capital to ensure the success of the project.
yy Additional Working Capital Requirements: A proposed investment may be expected
to increase payroll, expenses for supplies, or inventory requirements. This may result in
an indirect cash outflow that is recognized at the inception of the project because part
of the working capital of the organization will be allocated to the investment project and
will be unavailable for other uses in the organization.
yy Reduced Working Capital Requirements: Implementing a just-in-time inventory
system (in which the amount of inventory required to be on hand is reduced)
represents a decrease in current assets and is recognized as an indirect cash inflow at
the inception of the project.
  Disposal of the Replaced Asset
yy Asset Abandonment: If the replaced asset is abandoned, the net salvage value is
treated as a reduction of the initial investment in the new asset. The abandoned asset's
book value is considered a sunk cost, and therefore not relevant to the decision-making
process. The remaining book value (for tax purposes) is deductible as a tax loss, which
reduces the liability in the year of abandonment. This tax liability decrease is considered
a reduction of the new asset's initial investment.
yy Asset Sale: If a new asset acquisition requires the sale of old assets, the cash received
from the sale of the old asset reduces the new investment's value. If a gain or loss (for
tax purposes) exists, there is also a corresponding increase or decrease in income taxes.
The amount of income tax paid on a gain on a sale is treated as a reduction of the sales
price (which increases the initial expenditure). Conversely, a reduction in tax resulting
from a loss on a sale is treated as a reduction of the new investment.

2.3.2 Operations
The ongoing operations of the project will affect both direct and indirect cash flows of
the company.
  The cash flows generated from the operations of the asset occur on a regular basis. These
cash flows may be the same amount every year (an annuity) or may differ.
  Depreciation tax shields create ongoing indirect cash flow effects.

2.3.3 Disposal of the Project

Disposal of the investment at the end of the project produces direct or indirect cash flows.
  If the asset is sold, there is a direct effect for the cash inflow created on the sale and an
indirect effect for the taxes due (in the case of a gain) or saved (in the case of a loss).
  Certain direct expenses may be incurred for the disposal (e.g., severance pay).
  If the asset is scrapped or donated, there may be a tax savings (an indirect effect) if the net
tax basis is greater than zero (i.e., the asset has not been fully depreciated).
  There may be indirect effects associated with changes in the amount of working capital
committed once the project is disposed of (e.g., employees who worked on the project may
no longer be needed). A working capital commitment that was recognized as an indirect
cash outflow at the inception of a project is recognized as an indirect cash inflow at the end
of the project when the working capital commitment is released.

5–6 Module 1 E.1. Capital

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2.4 Calculation of Pretax and After-Tax Cash Flows LOS 2E1c

2.4.1 Pretax Cash Flows

The traditional computation of an asset's value is based on the cash flows it generates. Thus an
investment's value is often based on the present value of the future cash flows that investors
expect to receive from the investment. Larger cash outflows than inflows may indicate that a
project is unprofitable.

2.4.2 After-Tax Cash Flows

After-tax cash flows are relevant to capital budgeting decisions and are computed using either of
the following methods. Operating cash flow differs from net income because noncash expenses
like depreciation must be added back to net income to get to cash flow.
  Method 1
1. Estimate net operating cash inflows (cash inflows minus cash outflows).
2. Subtract noncash tax deductible expenses to arrive at taxable income.
3. Compute income taxes related to a project's income (or loss) for each year of the
project's useful life.
4. Subtract tax expense from net cash inflows to arrive at after-tax cash flows.
  Method 2
1. Multiply net operating cash inflows by (1 − Tax rate).
2. Add the tax shield associated with noncash expenses such as depreciation (depreciation
multiplied by the tax rate).
3. The sum of these two amounts will equal the after-tax cash flows.

Illustration 2 Methods of Calculating After-Tax Cash Flows

Compute after-tax cash flows based on the following facts:

Annual cash inflows $40,000

Depreciation 10,000
Tax rate 40%

Transaction Data Method 1 Method 2

Cash inflows $ 40,000 × (1 − 40%) = $24,000
Depreciation 10,000 × 40% = + 4,000
Pretax income 30,000 $28,000
Tax rate (12,000)
Net income $ 18,000

Cash inflows $ 40,000

Taxes (12,000)
After-Tax Cash Flows $ 28,000

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1 E.1. Capital Budgeting Process PART 2 UNIT 5

Example 1 Cash Flows for Capital Budgeting

Facts: The divisional management of Carlin Company has proposed the purchase of a new
machine that will improve the efficiency of the operations in the company's manufacturing
plant. The purchase price of the machine is $425,000. Costs associated with putting the
machine into service include $10,000 for shipping, $15,000 for installation, and $6,000 for
the initial training.
Carlin expects the machine to last six years and to have an estimated salvage value of
$7,000. The machine is expected to produce 4,000 units a year with an expected selling
price of $800 per unit and prime costs (direct materials and direct labor) of $750 per unit.
Tax depreciation will be computed under the accelerated straight-line rules (not MACRS)
for five-year property with no consideration for salvage value (i.e., the entire asset amount
capitalized will be depreciated). Carlin has a marginal tax rate of 40 percent.
Required: Calculate cash flows at the beginning of the first year (Year 0), for Years 1–5, and
for Year 6, which is the final year.
Solution: Cash flow at the beginning of the first year for capital budgeting analysis
The net cash outflow at the beginning of the first year is calculated as follows:
Initial investment $(425,000)
Shipping (10,000)
Installation (15,000)
Training (6,000)
Total $(456,000) [Outflow]
Sample year: Net cash flow for Years 1–5 for capital budgeting analysis
Net cash flow from sales $ 200,000 [4,000 × ($800 − $750)]
Less: taxes on net sales (80,000) [$200,000 × 0.40]
Add: net indirect effect of
depreciation on machine 36,480 [($456,000 / 5) × 0.40]
Total $ 156,480 [Inflow]
Net cash flow for the final year (Year 6) for capital budgeting analysis
Net cash flow from sales $ 200,000
Less: taxes on net sales (80,000)
Add: net indirect effect of
depreciation on machine -0- No depreciation in Year 6
Salvage value 4,200 [$7,000 gain × 0.60, net of tax]
Total $ 124,200 [Inflow]

5–8 Module 1 E.1. Capital

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3 Hurdle Rate LOS 2E1g

The hurdle rate is the minimum rate of return management expects to earn on a capital
investment. The hurdle rate is set by management and may differ from project to project
depending on project risk, the company's cost of capital, returns on similar investments, and
other factors that management believes may affect the investment.

3.1 Risk Adjustments LOS 2E1j

The higher the capital project's risk, the higher the return required by management. A higher
hurdle rate results in lower discounted cash flows, making a high-risk project appear less
profitable when compared to lower-risk projects discounted using lower hurdle rates.
Management should exercise care when setting a risk-adjusted hurdle rate. An overly high
rate could cause management to reject potentially profitable projects and to favor short-term
investments over long-term investments. Similarly, an overly low hurdle rate could result in the
acceptance of projects whose rate of return is not compatible with the risk being undertaken.

3.2 Effects of Inflation LOS 2E1f

Inflation should be part of management's evaluation when considering a capital project. It is

important to incorporate the effects of inflation when evaluating capital budgeting projects to
calculate the true return from the project. The hurdle rate should include the expected inflation
rate and should be increased if management anticipates higher-than-normal inflation. Future
cash flows should also be adjusted for the effects of expected inflation.

4 Evaluating Risk in Capital Budgeting

The three types of risk relevant to capital budgeting are stand-alone risk, contribution-to-firm
(corporate) risk, and systematic (market) risk.
  Stand-alone risk is the project's risk if it was the firm's only investment. Stand-alone risk is
the inherent risk of the investment, not influenced by the relative risk of the entity or the
market as a whole.
  Contribution-to-firm, or corporate risk, reflects the project's effect on the company as a
whole, considering the other investments of the entity. Corporate risk can be mitigated
through project diversification. A higher-risk project may not be a good investment if the
company already has high-risk projects, while a lower-risk project may serve to mitigate the
risks of other higher-risk projects.
  Systematic risk, or market risk, is risk that cannot be eliminated through capital project
diversification. Systematic risk is a product of changes in the market. Inflation, interest rate
fluctuation, and currency fluctuation are the most common sources of systematic risk.

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 1 E.1. Capital Budgeting Process PART 2 UNIT 5

LOS 2E1h 4.1 Adjusting for Risk in Capital Budgeting

The following methods can be used to adjust for higher risk in capital budgeting:
  Increasing the hurdle rate used to compute discounted cash flows.
  Risk-adjusting the estimated cash flows from the project by reducing estimated cash flows
that are less likely to be incurred or received.
  Delaying all cash flows by one year, which results in higher discounting and decreases the
value of the project.
  Decreasing the required payback period.

LOS 2E1i 4.2 Risk Analysis Techniques

Sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to analyze risk in
the capital budgeting process.

4.2.1 Sensitivity Analysis

Sensitivity analysis is used to evaluate how a change in assumptions can affect capital
investment analysis results. A base model (such as the project net present value) is developed
and each variable (interest rates, cash flows, life span) is changed to determine the change in the
net results (or project return).

4.2.2 Scenario Analysis

Scenario analysis is used to evaluate the consequences of an action under a different set of
factors. Scenario analysis differs from sensitivity analysis because scenario analysis allows more
than one variable to change at a time. Scenario analysis allows management to find the value of
the output desired based upon the best possible value for each input.

4.2.3 Monte Carlo Simulation

Monte Carlo simulation is a computerized mathematical technique that allows management to
account for risk in the decision-making process. Monte Carlo simulation furnishes the decision
maker with a range of possible outcomes and the probability that each outcome will occur for
any choice of action.

5 Other Capital Budgeting Considerations

LOS 2E1m 5.1 Qualitative Considerations

Financial gain is not the only determinant of management's decision to pursue an investment.
Management often considers qualitative factors to gain a clearer picture of the full effects of a
capital investment.
  Corporate Culture: Even if a project yields incremental cash flows and additional profit, the
project may not reflect the company's corporate culture. For example, if the employees are
averse to investment because of a perceived lack of fit with the company's mission, the lack
of support may lead to a less-than-successful investment.
  Environmental Impact: A company with a strong sense of environmental justice in its
mission or philosophy may reject an otherwise profitable capital project that has potentially
negative environmental impacts.

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  Social Trends: Management should evaluate current social trends and practices. If
management perceives that social trends may change during the life of an investment,
negatively affecting the profitability of the capital investment, management may not be
willing to commit to that investment.
  Strategic Impact: An analysis of the strategic impact also includes management's assessment
of the supply of inputs, the legal and regulatory environment, and political influences.

5.2 Capital Project Contingency Strategies LOS 2E1k

Making optimum capital budgeting decisions (e.g., whether to accept or reject a proposed LOS 2E1l
project) often requires recognizing and correctly accounting for flexibilities (real options)
associated with the project. Real options play a vital role in contingency planning during capital
budgeting and are used when the project return is not what management anticipated during
the planning phase. Real options provide management the flexibility to adjust project timelines
based on changes in economic conditions and changes in the market. This flexibility increases
the overall value of a capital project when compared with other projects that do not have
such flexibility.
  Expansion is adding a component to the initial capital investment. Adding an attachment to
equipment to allow the equipment to be used for more than one purpose is an example of
adding on. This strategy provides flexibility in asset use.
  Speeding up accelerates the investment in the capital project, providing the opportunity to
achieve the breakeven point earlier. Speeding up may accelerate the opportunity to free up
investment capital for future investment opportunities.
  Delaying, slowing down, or scaling back may be done in response to a temporary downturn
in the economy or the need for additional employee training.
  Abandoning or discontinuing a project early may be done if management determines
that, regardless of proper planning, economic conditions make it impossible to achieve
a profitable outcome. In this situation, management should terminate the investment to
mitigate losses.

Question 1 MCQ-12425

When evaluating a capital budgeting project, management should consider qualitative

factors. All of the following are qualitative considerations except:
a. Strategic factors such as social trends.
b. Environmental considerations and impact.
c. Financial modeling of the project.
d. Corporate culture.

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1 E.1. Capital Budgeting Process PART 2 UNIT 5

Question 2 MCQ-12282

Management should consider risk as part of management's evaluation of a capital

budgeting project. Which of the following is not one of the three types of capital budgeting
project risks that management should consider as part of its evaluation of a project?
a. Comparative project risk
b. Stand-alone risk
c. Systematic risk
d. Contribution-to-firm risk

Question 3 MCQ-12426

When analyzing a capital budgeting project, management can employ different types of risk
analysis. One of these risk analysis methods uses a computerized mathematical technique
that allows management to account for risk in the decision-making process. This method
furnishes the decision maker with a range of possible outcomes and the probabilities that
the outcomes will occur for any choice of action. This risk technique is known as:
a. Sensitivity analysis.
b. Monte Carlo simulation.
c. Function analysis.
d. Scenario analysis.

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2
MODULE
PART 2 UNIT 5

E.2. Capital Investment

Analysis Methods
Part 2
Unit 5

This module covers the following content from the IMA Learning Outcome Statements.

CMA LOS Reference: Part 2—Section E.2. Capital Investment Analysis Methods

The candidate should be able to:

a. demonstrate an understanding of the two main discounted cash flow (DCF) methods,
net present value (NPV) and internal rate of return (IRR)
b. calculate NPV and IRR
c. demonstrate an understanding of the decision criteria used in NPV and IRR analyses to
determine acceptable projects
d. compare NPV and IRR focusing on the relative advantages and disadvantages of each
method, particularly with respect to independent vs. mutually exclusive projects and
the "multiple IRR problem"
e. explain why NPV and IRR methods can produce conflicting rankings for capital
f. identify assumptions of NPV and IRR
g. evaluate and recommend project investments on the basis of DCF analysis
h. demonstrate an understanding of the payback and discounted payback methods
i. identify the advantages and disadvantages of the payback and discounted
payback methods
j. calculate payback periods and discounted payback periods

1 Discounted Cash Flow (DCF) LOS 2E2a

LOS 2E2f
DCF valuation methods (including the net present value and the internal rate of return methods)
are techniques that use time value of money concepts to measure the present value of cash
inflows and cash outflows expected from a project.

1.1 Objective and Components of Discounted Cash Flow

as Used in Capital Budgeting
The objective of the discounted cash flow (DCF) method is to focus the attention of management
on relevant cash flows appropriately discounted to present value. The factors used to evaluate
capital investments under discounted cash flow include the dollar amount of the initial
investment, the dollar amount of future cash inflows and outflows, and the rate of return
desired for the project.

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 2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

1.1.1 Rate of Return Desired for the Project

The rate used to discount future cash flows may be set by management using several different
approaches. Management may use a weighted average cost of capital (WACC) method, a specific
target rate assigned to new projects, or a rate that relates to the risk specific to the proposed
project. If the proposed project is similar in risk to the ongoing projects of the company,
WACC is appropriate because it reflects the market's assessment of the average risk of the
company's projects.

1.1.2 Limitation of Discounted Cash Flow: Simple Constant Growth Assumption

Discounted cash flow methods are widely viewed as superior to methods that do not consider
the time value of money. However, discounted cash flow methods do have an important
limitation—they frequently use a single interest rate assumption. This assumption is often
unrealistic because, over time, as management evaluates its alternatives, actual interest rates or
risks may fluctuate.

2 Net Present Value Method (NPV)

2.1 Objective
The objective of the net present value method is to focus decision makers on the initial
investment amount that is required to purchase (or invest in) a capital asset that will yield
returns in an amount in excess of a management-designated hurdle rate.
NPV requires managers to evaluate the dollar amount of return rather than either percentages
of return (as with the internal rate of return method) or years to recover principal (as with the
payback methods) as a basis for screening investments.

LOS 2E2b 2.2 Calculation of Net Present Value

Net present value is calculated as follows:

1. Estimate the Cash Flows

Estimate all direct and indirect after-tax cash flows (both inflows and outflows) related to
the investment.
y Ignore Depreciation (Unless a Tax Shield)
As with DCF methods, depreciation is ignored except to the extent that it reduces tax
payments (i.e., a tax shield). Use of accelerated (instead of straight-line) depreciation
methods increases the present value of the depreciation tax shield.
y Ignore Interest Expense
The discounting process itself deals with the cost of financing the project, and therefore
finance costs are excluded from the cash flow forecast.

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2. Discount the Cash Flows

Discount all cash flows (both inflows and outflows) to present value using the appropriate
discount factor based on the hurdle rate and the timing of the cash flow. The net present
value method assumes that the cash flows are reinvested at the same rate used in
the analysis.

3. Compare
Compare the present values of inflows and outflows.

Pass Key

Discounted cash flow is the basis for net present value methods:
  Step 1: Calculate after-tax cash flows = Annual net cash flow × (1 − Tax rate)
  Step 2: Add depreciation benefit = Depreciation × Tax rate
  Step 3: Multiply result by appropriate present value (use present value of an annuity if
the cash flows are an annuity; otherwise, use present value of a lump sum)
  Step 4: Subtract initial cash outflow
Result: Net present value

2.3 Interpreting the NPV Method LOS 2E2c

The investment decision is based on whether the net present value is positive or negative. Note
that if the net present value is equal to zero, management would be indifferent about accepting
or rejecting the project. NPV is the theoretical dollar change in the market value of the firm's
equity due to the project.

2.3.1 Positive Result = Make Investment

If the result is positive (greater than zero), the rate of return for the project is greater than the
hurdle rate (the discount percentage rate used in the net present value calculation) and the
investment should be made. If the company has unlimited funds, all projects with a net present
value greater than zero should be accepted. Project ranking and acceptance techniques in
circumstances involving limited capital are described below.

2.3.2 Negative Result = Do Not Make Investment

If the result is negative (less than zero), the rate of return for the project is less than the hurdle
rate and the investment should not be made because it does not meet management's minimum
rate of return. A negative NPV means that the internal rate of return on the investment is less
than management's hurdle rate for the project.

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2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

Illustration 1 Calculating Net Present Value

Carson's Candy Co. would like to purchase a new modern candy machine, which would
cost $24,000. Carson anticipates that the new machine will aid in the production of the
company's famous chocolate squares and will increase net, before-tax cash flows for the
next eight years by $5,000 per year without any change in net working capital. In order to
move forward with the purchase, the company accountant has been asked to calculate the
NPV of this purchase. The details and facts are as follows:
——Income tax rate: 20%
——Depreciation expense: $3,000 per year
——There is no salvage value for the old machine.
——PV factor for an annuity for 8 years at 10 percent (rounded to 3 places): 5.335
The accountant determines whether this purchase is a good investment for the candy
company by comparing the present value of the yearly after-tax cash flows with the
$24,000 purchase price of the chocolate-making machine.
After-tax cash inflow [$5,000 × (1 − 20%)] $ 4,000
Depreciation tax shield ($3,000 × 20%) 600
After-tax cash flow $ 4,600
Annuity factor × 5.335
Present value of after-tax cash flows 24,541
Cost of the investment (24,000)
NPV $ 541

Because NPV is positive, management decides to make the purchase.

Example 1 Net Present Value

Facts: McLean Inc. is considering the purchase of a new machine, which will cost $150,000.
The machine has an estimated useful life of three years. Assume for simplicity that the
equipment will be fully depreciated for tax purposes 30 percent, 40 percent, and 30 percent
in each of the three years, respectively. The new machine will have a $10,000 resale value at
the end of its estimated useful life. The machine is expected to save the company $85,000
per year in operating expenses. McLean uses a 40 percent estimated income tax rate and a
16 percent hurdle rate to evaluate capital projects.
Discount rates for a 16 percent rate are as follows:
Present Value of
Present Value of $1 an Ordinary Annuity of $1
Year 1 0.862 0.862
Year 2 0.743 1.605
Year 3 0.641 2.246
Required: Calculate the net present value of the proposed purchase of the new machine.

(continued)

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PART 2 UNIT
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(continued)

Solution:
1. Annual Depreciation Shield
First, calculate the annual depreciation tax shield as follows (Depreciation × Tax rate):
Years 1 and 3 (30%) Year 2
Cost of asset $150,000 $150,000
Depreciation % × 30% × 40%
Annual depreciation $ 45,000 $ 60,000
Tax rate × 40% × 40%
Tax shield $ 18,000 $ 24,000

2. Annual Savings
Calculate the after-tax annual savings as follows [Savings × (1 − Tax rate)]:
Annual savings = $85,000 [savings per year] × (1 − 0.40)
Annual savings = $85,000 × 0.60
Annual savings = $51,000

3. Salvage Value Inflow

Calculate the salvage value inflow as follows:
Proceeds from salvage $10,000
Less: basis of machine — [fully depreciated]
Gain on salvage $10,000
Less: taxes (4,000) [$10,000 × 40%]
Cash inflow $ 6,000 [$10,000 × (1 − 0.40)]

4. Net Present Value Schedule and Calculation

Year 0 Year 1 Year 2 Year 3
Equipment cost $(150,000)
Depreciation tax shield $18,000 $24,000 $18,000 [from 1, above]
Annual savings 51,000 51,000 51,000 [from 2, above]
Salvage value inflow 6,000 [from 3, above]
After-tax cash flow (150,000) 69,000 75,000 75,000
Discount rate × 1.00 × 0.862 × 0.743 × 0.641
Present value (150,000) 59,478 55,725 48,075 = $13,278

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 2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

2.4 Advantages and Limitations of the Net Present Value Method

2.4.1 Advantages
The net present value method is flexible and can be used when there is no constant rate of
return required for each year of the project.

2.4.2 Limitations
Even though NPV is considered the best single technique for capital budgeting, the net present
value method of capital budgeting is limited by not providing the true rate of return on the
investment. The NPV purely indicates whether an investment will earn the "hurdle rate" used in
the NPV calculation.

3 Internal Rate of Return (IRR)

The internal rate of return (IRR) is the expected rate of return of a project and is sometimes
called the time-adjusted rate of return.

3.1 Objective
The IRR method determines the present value factor (and related interest rate) that yields an
NPV equal to zero. (The present value of the after-tax net cash flows equals the initial investment
on the project.)
The IRR method focuses the decision maker on the discount rate at which the present value of
the cash inflows equals the present value of the cash outflows (usually the initial investment).

Pass Key

Although the NPV method highlights dollar amounts, the IRR method focuses decision
makers on percentages.

LOS 2E2b 3.2 Interpreting IRR for Investment Decisions

The targeted rate of return or hurdle rate is predetermined by management and is compared
with the computed IRR. Note that management would be indifferent about accepting or rejecting
the project if the IRR were equal to the hurdle rate.
  Accept When IRR > Hurdle Rate: Projects with an IRR greater than the hurdle rate
will be accepted.
  Reject When IRR < Hurdle Rate: Projects with an IRR less than the hurdle rate will be rejected.

5–18 Module 2 E.2. Capital

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PART 2 UNIT
2 5 E.2. Capital Investment Analysis Methods

Illustration 2 Internal Rate of Return

Slater & Co. is considering an investment of $250,000 to start a shoe manufacturing business.
The hurdle rate for the investment is 10 percent.
Slater & Co. anticipates that the cash flows for the first four years will be as follows:
y Year 1: $10,000
y Year 2: $60,000
y Year 3: $100,000
y Year 4: $250,000
Present Value
Year 1 Year 1 Year 2 Year 3 Year 4 at 10%

Initial outflow ($250,000) ($250,000)

Inflows $10,000 $60,000 $100,000 $250,000
Discounted cash
flows at 10% $9,091 $49,587 $75,131 $170,753 304,562
NPV $ 54,562

IRR* 16.75%

*Note: IRR cannot easily be calculated by hand and is generally calculated using a
financial calculator.
Since the IRR is greater than Slater & Co.'s hurdle rate of 10%, this investment is
appropriate for the company. NPV does not need to be calculated to determine IRR. This
illustration shows that when the IRR is greater than the hurdle rate, the NPV is positive.

4 Comparison of NPV and IRR LOS 2E2d

NPV and IRR are superior to other capital budgeting methods because they consider the time
value of money. Each method has its relative advantages and disadvantages.

4.1 Advantages and Disadvantages of Net Present Value

The net present value method is considered to be the best technique for capital budgeting because
it is flexible and can be used when there are different rates of return or nonconventional cash flows
each year of the project. NPV also makes the assumption that cash flows generated by the project
are reinvested at the hurdle rate, which is more realistic than the reinvestment assumption under
IRR. However, net present value does not provide the true rate of return on the project. A positive
NPV only indicates that the true rate of return is higher than the hurdle rate.

4.2 Advantages and Disadvantages of Internal Rate of Return

The internal rate of return method provides the true rate of return on a project but does not
provide the actual dollar amount of the return. IRR has two significant disadvantages when
compared with NPV.

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 2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

4.2.1 Unreasonable Reinvestment Assumption

Under IRR, the cash flows generated by the project are assumed to be reinvested at the internal
rate of return. If the IRR is significantly higher or lower than the hurdle rate, assumed returns on
reinvested cash flows based on the IRR can lead to inappropriate conclusions.

4.2.2 Inflexible Cash Flow Assumption (Multiple IRR Problem)

The IRR method is less reliable than the NPV method when there are several alternating periods
of cash inflows and outflows. In a conventional capital budgeting problem, the project has a cash
outflow followed by multiple periods of cash inflows. This situation results in the calculation of a
single IRR. However, when a project has nonconventional cash flows that alternate between periods
of cash outflow and cash inflow, the IRR calculation can result in multiple IRRs or even no IRR. When
a project has nonconventional cash flows, NPV should be used to make the investment decision.

LOS 2E2e 4.3. Independent vs. Mutually Exclusive Projects

LOS 2E2g NPV and IRR are often used together because NPV provides an estimated dollar return while
IRR provides an estimated rate of return. For independent projects, NPV and IRR will result in
the same investment decision because a positive NPV equates to an IRR greater than the hurdle
rate, and a negative NPV equates to an IRR less than the hurdle rate. However, NPV and IRR can
result in different project rankings in the case of two or more mutually exclusive projects. When
NPV and IRR rank projects differently, NPV should be used to make the investment decision
because it has the more realistic reinvestment assumption.

Illustration 3 Mutually Exclusive Projects

Brown Co. must make the decision to invest in only one of the following two projects. The
hurdle rate for both projects is 15 percent.
Cash Flow
Year 0 Year 1 Year 2 Year 3 NPV IRR
Project A $(150,000) $80,000 $80,000 $ 80,000 $32,658 27.76%
Project B $(150,000) $ - $ - $300,000 $47,255 25.99%
Project A has a lower NPV and a higher IRR, whereas Project B has a higher NPV and a
lower IRR. Because these projects are mutually exclusive, Brown should choose to invest in
Project B, the project with the higher NPV.

LOS 2E2h 5 Payback Period Method

LOS 2E2i
The payback period is the time required for the net after-tax operating cash inflows to recover
the initial investment in a project.

5.1 Objective
The payback period method focuses decision makers on both liquidity and risk. The payback
period method measures the time it will take to recover the initial investment in the project,
thereby emphasizing the project's liquidity and the time during which return of principal is
at risk. The payback method is often used for risky investments. The greater the risk of the
investment, the shorter the payback period that is expected (tolerated) by the company.

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PART 2 UNIT
2 5 E.2. Capital Investment Analysis Methods

5.2 Calculation LOS 2E2j

The formula for calculating the payback period is as follows, assuming equal annual cash flows:

Net initial investment

Payback period =
Average incremental cash flow*
* Where the cash flow per period is even.

5.3 Cash Flow Assumptions

5.3.1 Uniform Cash Inflows
The net cash inflows are generally assumed to be constant for each period during the life of the
project. The payback period is computed at the point of initial investment using after-tax cash
flows. Cash flows involve the following factors:
  Project Evaluation: In the case of a project, the net annual cash inflow would be the net
cash receipts associated with the project.
  Asset Evaluation: In the case of the purchase of equipment, the net annual cash inflow will
be the savings generated by use of the new equipment.
  Depreciation Tax Shield: Depreciation expense is not considered, except to the extent that
it is a tax shield.

Example 2 Uniform Cash Flows

Facts: Helena Company is planning to acquire a $250,000 machine that will provide
increased efficiencies, thereby reducing annual operating costs by $80,000. The machine
will be depreciated by the straight-line method over a five-year life with no salvage value at
the end of five years.
Required: Assuming a 40 percent income tax rate, calculate the machine's payback period.
Solution:
1. Calculate the annual net cash savings (also referred to as the average expected cash
flows) as follows:
Expected cash flow savings $ 80,000
Net income increase $ 80,000
Less: annual depreciation (50,000)
Net income before income taxes $ 30,000
Multiplied by 40% tax rate × 40% (12,000)
Net cash savings $ 68,000
2. Calculate the payback period, as follows:
Investment $250,000
= = 3.68 years
Net cash savings $68,000

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2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

5.3.2 Non-uniform Cash Flows (Use Cumulative Approach)

The standard payback formula shown above applies to uniform annual cash inflows. If cash
flows are not uniform (i.e., they vary from period to period over the life of the project), a
cumulative approach (rather than the standard payback formula) to determine the payback
period is used. Net after-tax cash inflows are accumulated until the time they equal the initial net
investment (at which point the end of the payback period is reached).

Example 3 Non-uniform Cash Flows

Facts: Radon Technologies is considering the purchase of a new machine costing $200,000
for its surfboard manufacturing plant in San Diego, CA. The management of Radon
estimates that the new machine will last approximately four years and will be directly
responsible for efficiencies that will increase the company's after-tax cash flows by the
following amounts:
Cumulative Amounts
Year 1 $90,000 $ 90,000
Year 2 80,000 170,000
Year 3 75,000 245,000
Year 4 60,000 305,000
Required: Calculate the payback period for this investment.
Solution: The cumulative cash flows reach the initial investment amount of $200,000
sometime in Year 3.
Therefore, the payback period would be more than two years and less than three years.
Assume that the cash flow is earned evenly throughout the year. The payback period is
then calculated as follows:
1. Amount of cash flow in Year 3 needed to attain $200,000 cumulative cash flows:
$200,000 − $170,000 (Year 2's cumulative amount) = $30,000
2. Percentage of Year 3 until cumulative amount of $200,000 is attained:
$30,000
= 40%
$75,000
3. 2 + 0.40 = 2.40 years payback

5–22 Module 2 E.2. Capital

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PART 2 UNIT
2 5 E.2. Capital Investment Analysis Methods

5.4 Identify Advantages and Disadvantages of the Payback Method LOS 2E2i

5.4.1 Advantages of the Payback Method

  Easy to Use and Understand: The simplicity of the objective and the absence of complex
formulas or multiple steps make the payback method easy to use and understand.
  Emphasis on Liquidity: The computation focuses management on return of principal.
The method's emphasis on liquidity is a very important consideration when making capital
budgeting decisions (e.g., most companies will prefer shorter payback periods, all other factors
being equal).

5.4.2 Limitations of the Payback Method

  The time value of money is ignored.
  Project cash flows occurring after the initial investment is recovered are not considered.
  Reinvestment of cash flows is not considered.
  Total project profitability is neglected.

6 Discounted Payback Method LOS 2E2h

LOS 2E2j
Companies may use the discounted payback method as an alternative to the nondiscounted
payback method. This variation computes the payback period using expected cash flows that
are discounted by the project's cost of capital (the method considers the time value of money).
Discounted payback is also referred to as the breakeven time method (BET).

6.1 Objective
The objective of the discounted payback method (or BET) is to evaluate how quickly new ideas
are converted into profitable ideas.
  Focus on Liquidity and Profit: The measure focuses decision makers on the number of
years needed to recover the investment from discounted net cash flows.
  Evaluation Term: The computation begins when the project team is formed and ends when
the initial investment has been recovered (based on cumulative discounted cash flows).
  Using Discounted Payback: Discounted payback (or BET) is often used to evaluate new
product development projects of companies that experience rapid technological changes.
These companies want to recoup their investment quickly, before their products become
obsolete.

6.2 Advantages and Limitations of Discounted Payback LOS 2E2i

The advantages and limitations of discounted payback are the same as the payback method
(except that discounted payback incorporates the time value of money, a feature ignored by
the payback method). Both focus on how quickly the investment is recouped rather than overall
profitability of the entire project.

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2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

Example 4 Discounted Payback

Facts: Radon Technologies is considering the purchase of a new machine costing

$200,000 for its surfboard manufacturing plant in San Diego, CA. The company's discount
rate for projects of this type is 10 percent. The management of Radon estimates that
the new machine will last approximately four years and will be directly responsible for
efficiencies that will increase the company's after-tax cash flows by the following amounts
(non‑uniform cash flow):
Year 1 $90,000
Year 2 80,000
Year 3 75,000
Year 4 60,000
The present value interest factors for 10 percent are as follows:
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Required: Calculate the discounted payback period for this investment.
Solution:
1. Calculate the present value of the future cash flows:
Cash Flow Discount 10% PV of
Year Increase Factor Cash Flow Cumulative PV
Year 1 $ 90,000 0.909 $ 81,810 $ 81,810
Year 2 80,000 0.826 66,080 147,890
Year 3 75,000 0.751 56,325 204,215
Year 4 60,000 0.683 40,980 245,195
$305,000 $245,195
2. Determine the discounted payback period:
The cumulative present value reaches the initial investment amount of $200,000 in
Year 3. Therefore, the discounted payback period would be more than two years and
less than three years. Assume that the cash flow is earned evenly throughout the year.
The discounted payback period is then calculated as follows:
yy Amount of cash flow in Year 3 needed to attain $200,000 cumulative cash flows:
$200,000 − $147,890 (Year 2's cumulative amount) = $52,110
yy Percentage of Year 3 until cumulative amount of $200,000 is attained:
$52,110
= 92.5%
$56,325
yy 2 + 0.925 = 2.925 years discounted payback

5–24 Module 2 E.2. Capital

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PART 2 UNIT
2 5 E.2. Capital Investment Analysis Methods

Question 1 MCQ-12427

The IRR method evaluates investment alternatives based on the achieved IRR. IRR
methodology to accept or reject a capital budgeting project has limitations. All of the
following are limitations of the IRR method except:
a. If internal rates of return are unrealistically high or low, IRR rates could lead to
inappropriate conclusions.
b. IRR method does not consider the market rate of interest and seeks to determine
the maximum rate of interest at which funds invested in any project could
be repaid.
c. IRR evaluation method becomes easier when the capital project has variations in
cash flows and the timing of cash flows.
d. Using IRR assumes that the reinvestment rate will be equal to the IRR and that
each cash flow will be reinvested at the same interest rate.

Question 2 MCQ-12428

Slater Five Star Foods (SFSF) is planning to purchase a new meat processor machine for
$250,000 and asked its accountant how many years must elapse in order for SFSF to
recoup the $250,000 investment. SFSF provided the following schedule of after-tax cash
flow savings from this purchase:
Year 1 $65,000
Year 2 $75,000
Year 3 $55,000
Year 4 $80,000
Year 5 $45,000
What is the payback period for the new meat processing packing machine?
a. 3.31
b. 3.69
c. 4.00
d. 4.22

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2 E.2. Capital Investment Analysis Methods PART 2 UNIT 5

Question 3 MCQ-12429

Invincible OB GYN Inc. wants to purchase a new ultrasound medical unit having the newest
technology. Hologram PLLC has made a presentation to the physicians, who are most
interested. The cost of the unit is $65,000, which includes a two-year warranty. The warranty
has a value of $24,000 but is included in the price of the machine. Invincible anticipates that
the new unit will yield a higher-level image resulting in increased profits of $22,000 per year
during the unit's seven-year life. To move forward with the purchase, the physicians ask their
accountant to calculate the NPV of this purchase. The details and facts are as follows:
yyHologram ultrasound machine: $65,000
yyPurchasing, using, and disposing of the unit will not affect working capital requirements.
yyNet, after-tax cash flows per year: $22,000
yyAfter seven years, the scrap value of the unit will equal the costs of removal and
disposition of the unit.
yyDiscount rate: 9 percent
yyPV factor (9 percent) for an annuity for seven years: 5.03295
yyPV factor (9 percent) of a lump sum for two years: 0.84168
Calculate the net present value of the new ultrasound machine using the fact pattern above.
a. $45,724
b. $65,924
c. $69,724
d. $89,000

5–26 Module 2 E.2. Capital

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Class Question Explanations Part 2

UNIT 5

Unit 5, Module 1

1. MCQ-12425
Choice "c" is correct. Qualitative considerations are subjective in nature and hard to measure.
Qualitative considerations when evaluating a capital budgeting project include strategic factors
such as social trends, environmental considerations, and whether the project is a fit for the
company culturally.
Quantitative factors can be evaluated numerically. Financial modeling is not a qualitative
consideration but, rather, a quantitative consideration. Financial modeling is the process of
using numerical data to display the possible outcome of a real-world financial situation.
Choice "a" is incorrect. Strategic factors are a qualitative consideration. Strategic factors include
the company goals and plan of action to achieve the company goals
Choice "b" is incorrect. Environmental considerations and impact are a qualitative consideration.
Environmental considerations are normally entertained by a company that cares about the
environment and one that wants to maintain its integrity. The environmental impact is hard
to measure as a single contributor. However, companies choose to prioritize environmental
considerations as moral priority.
Choice "d" is incorrect. Corporate culture and whether the project is a fit for the company is a
qualitative consideration. Many companies can choose to add segments to its business because
they will add profit to the bottom line. However, if the employees are not passionate about the
product line because it does not fit the normal motif of the company, the product line may not
be successful.

2. MCQ-12282
Choice "a" is correct. Business risk, in general, is the risk the business may not yield a profit.
There are risks that can be evaluated and identified in relation to the company as a whole.
Evaluation of the risk of a project includes identifying and considering stand-alone risk,
contribution-to-firm risk, or systematic risk.
Comparative project risk is not a risk element in capital budgeting evaluation.
Choice "b" is incorrect. When management evaluates a project and considers stand-alone risk,
the evaluation of the risk of the capital budgeting project is based upon the assumption that the
project is the company's only project.
Choice "c" is incorrect. When management evaluates a project and considers systematic risk, the
evaluation of the risk of the capital budgeting project considers the extent to which that project's
risk cannot be eliminated through capital project diversification.
Choice "d" is incorrect. When management evaluates a project and considers contribution-to-
firm risk, the evaluation of the risk of the capital budgeting project considers the impact of the
project's risk on the company as a whole.

© Becker Professional Education Corporation. All rights reserved. CQ–41

Part 2 Class Question Explanations

3. MCQ-12426
Choice "b" is correct. There are a few methods that companies can use to project and manage
risk. Risk analysis allows a company to be prepared for different outcomes. The three
most common risk analysis methods are sensitivity analysis, scenario analysis, and Monte
Carlo simulation.
Monte Carlo simulation is a computerized mathematical technique that allows management to
account for risk in the decision-making process. Monte Carlo simulation furnishes the decision
maker with a range of possible outcomes and the probability that each outcome will occur for
any choice of action.
Choice "a" is incorrect. Sensitivity analysis is a "what if" look at how changes in the variable
assumptions impact the net result. The first step is to develop a base model. From that point,
variables can be changed one at a time to see how that change impacts the net result.
Choice "c" is incorrect. Function analysis is not a type of risk analysis.
Choice "d" is incorrect. Scenario analysis looks at consequences of an action under a different
set of factors. Scenario analysis differs from sensitivity analysis because scenario analysis allows
more than one variable to change at the same time. Scenario analysis allows management the
opportunity to find the value of the output management desires based upon the best possible
value for each input.

Unit 5, Module 2

1. MCQ-12427
Choice "c" is correct. Limitations of the IRR method include false conclusions if internal rates of
return are set too high or too low; IRR does not consider the market rate of interest; and the IRR
method assumes that each cash flow will be reinvested at the same interest rate. Interest rates
do change often; thus, this assumption adversely impacts the reliability of the IRR calculation.
The IRR method is neither easier nor more difficult when there are several alternating
periods of net cash inflows and net cash outflows and/or when the amounts of the cash flows
differ significantly.
Choice "a" is incorrect. If the internal rate of return is unrealistically high or low, IRR can lead to
inappropriate conclusions. This inappropriate conclusion is a limitation of IRR.
Choice "b" is incorrect. IRR does not consider the market rate of interest or a company's cost of
capital. The goal of the IRR method is to determine which potential project generates the highest
internal rate of return.
Choice "d" is incorrect. IRR assumes that the reinvestment rate will be equal to the IRR, but
that assumption is not always correct. Because this assumption is not always correct is a
limitation of IRR.

CQ–42 © Becker Professional Education Corporation. All rights reserved.

Class Question Explanations Part 2

2. MCQ-12428
Choice "b" is correct. The payback period method focuses decision makers on both liquidity
and risk. The payback period method measures the time necessary for the business to recover
the initial investment in the project and thereby emphasizes the project's liquidity and the time
during which return of principal is at risk.
The problem is calculated by adding the Year 1, 2, and 3 after-tax cash flows ($65,000 + 75,000 +
$55,000 = $195,000) and subtracting the cost of the investment ($250,000) to get the remaining
cash flow for Year 4 ($55,000). The Year 4 amount needed for payback ($55,000) is then divided
by the total year cash flow ($80,000) to get the portion of the year until payback is achieved
(0.6975). Therefore, the payback period for the project is 3.69 years (rounded) until the company
recoups the $250,000 investment.
Choice "a" is incorrect. This answer is the sum of the first three full years plus 0.31 of the fourth
year. However, 0.31 from Year 4 is the portion of the year after the 0.69 of the fourth year, which
is necessary to achieve the payback period.
Choice "c" is incorrect. This answer does not prorate the fourth year. Per the analysis, above,
only 0.6975 of the fourth-year, after-tax cash flows, along with the first three years, are
necessary to recoup the $250,000 investment.
Choice "d" is incorrect. 4.22 is a "wild card" incorrect number because the payback period is 3.69
years per the analysis, above.

3. MCQ-12429
Choice "a" is correct. The accountant will determine whether the purchase of the ultrasound unit
is beneficial for the company by comparing the present value of the $65,000 cost of the unit to
the present value of the seven-year, after-tax cash flow of $22,000 at the end of each year for
seven years. Note that (i) there is no change in working capital, and (ii) the end of Year 7 cash
flow attributable to disposing the unit is 0 because the salvage of the unit will equal the costs
of removal and disposition of the unit. The present value of the seven-year, after-tax cash flow
of $22,000 at the end of each year for seven years is $110,724: $22,000 after-tax cash flow per
year at the end of each year for seven years × 5.03295 present value annuity factor at 9 percent
for seven years.
NPV of the investment is $45,724: $110,724 present value of the seven-year, after-tax cash flow
of $22,000 per year at the end of each year minus $65,000 cost of the unit = $45,724.
Choice "b" is incorrect. $65,924 is the sum of the $45,724 NPV plus $20,200, which is the PV of
the $24,000 value of the warranty, which is included in the $65,000 price of the unit. $24,000
value of warranty × 0.84168 present value factor for two years at 9 percent per year = $20,200.
Choice "c" is incorrect. $69,724 is the sum of the $45,724 NPV plus $24,000 value of the warranty,
which is included in the $65,000 cost of the unit.
Choice "d" is incorrect. $89,000 is the sum of the $65,000 cost of the machine plus the $24,000
value of the warranty, which is included in the $65,000 cost of the unit.

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Part 2 Class Question Explanations

NOTES

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