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Chapter 12: The Capital Budgeting Decision
12-1
Chapter 12
The Capital Budgeting Decision
Discussion Questions
12-1.
What are the important administrative considerations in the capital budgeting
process?
Important administrative considerations relate to: the search for and discovery
of investment opportunities, the collection of data, the evaluation of projects,
and the reevaluation of prior decisions.
12-2.
Why does capital budgeting rely on analysis of cash flows rather than on net
income?
Cash flow rather than net income is used in capital budgeting analysis because
the primary concern is with the amount of actual dollars generated. For
example, depreciation is subtracted out in arriving at net income, but this non-
cash deduction should be added back in to determine cash flow or actual dollars
generated.
12-3.
What are the weaknesses of the payback method?
The weaknesses of the payback method are:
a. There is no consideration of inflows after payback is reached.
b. The concept fails to consider the time value of money.
12-4.
What is normally used as the discount rate in the net present value method?
The cost of capital as determined in Chapter 11.
12-5.
What does the term mutually exclusive investments mean?
The selection of one investment precludes the selection of other alternative
investments because the investments compete with one another. For example if
a company is going to build one new plant and is considering 5 cities, one city
will win and the others will lose.
12-6.
How does the modified internal rate of return include concepts from both the
traditional internal rate of return and the net present value methods?
The modified internal rate of return calls for the determination of the interest
rate that equates future inflows to the investment as does the traditional internal
rate or return. However, it incorporates the reinvestment rate assumption of the
net present value method. That is that inflows are reinvested at the cost of
capital.
Chapter 12: The Capital Budgeting Decision
12-7.
If a corporation has projects that will earn more than the cost of capital, should
it ration capital?
From a purely economic viewpoint, a firm should not ration capital. The firm
should be able to find additional funds and increases its overall profitability and
wealth through accepting investments to the point where marginal return equals
marginal cost.
12-8.
What is the net present value profile? What three points should be determined
to graph the profile?
The net present value profile allows for the graphic portrayal of the net present
value of a project at different discount rates. Net present values are shown along
the vertical axis and discount rates are shown along the horizontal axis.
The points that must be determined to graph the profile are:
a. The net present value at zero discount rate.
b. The net present value as determined by a normal discount rate.
c. The internal rate of return for the investment.
12-9.
How does an asset's ADR (asset depreciation range) relate to its MACRS
category?
The ADR represents the asset depreciation range or the expected physical life
of the asset. Generally, the midpoint of the range or life is utilized. The longer
the ADR midpoint, the longer the MACRS category in which the asset is
placed. However, most assets can still be written off more rapidly than the
midpoint of the ADR. For example, assets with ADR midpoints of 10 years to
15 years can be placed in the 7-year MACRS category for depreciation
purposes.
Chapter 12
Problems
1. Cash flow (LO2) Assume a corporation has earnings before depreciation and taxes of
$100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its
cash flow using the format below.
Chapter 12: The Capital Budgeting Decision
12-3
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
12-1. Solution:
Earnings before depreciation and taxes $100,000
Depreciation – 50,000
2. Cash flow (LO2)
a. In problem 1, how much would cash flow be if there were only $10,000 in
depreciation? All other factors are the same.
b. How much cash flow is lost due to the reduced depreciation between Problems
1 and 2a?
12-2. Solution:
a. Earnings before depreciation and taxes $100,000
Depreciation – 10,000
Earnings before taxes 90,000
Chapter 12: The Capital Budgeting Decision
12-4
3. Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $500,000
and no depreciation. It is in a 40 percent tax bracket.
a. Compute its cash flow.
b. Assume it has $500,000 in depreciation. Recompute its cash flow.
c. How large a cash flow benefit did the depreciation provide?
12-3. Solution:
a. Earnings before depreciation and taxes $ 500,000
Depreciation – 0
Earnings before taxes 500,000
b. Earnings before depreciation and taxes $500,000
Depreciation –500,000
Chapter 12: The Capital Budgeting Decision
12-5
4. Cash flow (LO2) Assume a firm has earnings before depreciation and taxes of $400,000
and depreciation of $100,000.
a. If it is in a 35 tax bracket, compute its cash flow.
b. If it is in a 20 tax bracket, compute its cash flow.
12-4. Solution:
a. Earnings before depreciation and taxes $400,000
Depreciation 100,000
Earnings before taxes 300,000
b. Earnings before depreciation + taxes $400,000
Depreciation 100,000
5. Cash flow versus earnings (LO2) A1 Quick, the president of a New York Stock
Exchange-listed firm, is very short term oriented and interested in the immediate
consequences of his decisions. Assume a project that will provide an increase of $2 million
in cash flow because of favorable tax consequences, but carries a two-cent decline in
earning per share because of a write-off against first quarter earnings. What decision might
Mr. Quick make?
12-5. Solution:
Chapter 12: The Capital Budgeting Decision
12-6
A1 Quick
Being short term oriented, he may make the mistake of
turning down the project even though it will increase cash flow
because of his fear of investors’ negative reaction to the more
widely reported quarterly decline in earnings per share. Even
though this decline will be temporary, investors might interpret it
as a negative signal.
6. Payback method (LO3) Assume a $200,000 investment and the following cash flows for
two products:
Year
Product X
Product Y
1
$60,000
$40,000
2
90,000
70,000
3
50,000
80,000
4
40,000
20,000
Which alternatives would you select under the payback method?
12-6. Solution:
Payback for Product X Payback for Product Y
$200,000 – 60,000 1 year $200,000 – 40,000 1 Year
Payback Product X = 3.00 years
Chapter 12: The Capital Budgeting Decision
12-7
7. Payback method (LO3) Assume a $50,000 investment and the following cash flows for
two alternatives.
Year
Investment A
Investment B
1 ................
$10,000
$20,000
2 ................
11,000
25,000
3 ................
13,000
15,000
4 ................
16,000
—
5 ................
30,000
—
Which alternative would you select under the payback method?
12-7. Solution:
Payback for Investment A Payback for Investment B
$50,000 –$10,000 1 year $50,000 – $20,000 1 year
Payback Investment A = 4.00 years
8. Payback method (LO3) Referring back to Problem 7, if the inflow in the fifth year for
Investment A were $30,000,000 instead of $30,000, would your answer change under the
payback method?
12-8. Solution:
B under the payback method.
Chapter 12: The Capital Budgeting Decision
12-8
9. Payback method (LO3) The Short-Line Railroad is considering a $100,000 investment in
either of two companies. The cash flows are as follows:
Year
Electric Co.
Water Works
1 ..................
$70,000
$15,000
2 ..................
15,000
15,000
3 ..................
15,000
70,000
4–10 ............
10,000
10,000
a. Using the payback method, what will the decision be?
b. Explain why the answer in part a can be misleading.
12-9. Solution:
Short-Line Railroad
a.
Payback for Electric Co. Payback for Water Works
$100,000 – $70,000 1 year $100,000 – $15,000 1 year
b. The answer in part a) is misleading because the two
investments seem to be equal with the same payback period
Chapter 12: The Capital Budgeting Decision
12-9
10. Payback and net present value (LO3 & 4) Diaz Camera Company is considering two
investments, both of which cost $10,000. The cash flows are as follows:
Year
Project A
Project B
1 .....................
$6,000
$5,000
2 .....................
4,000
3,000
3 .....................
3,000
8,000
a. Which of the two projects should be chosen based on the payback method?
b. Which of the two projects should be chosen based on the net present value method?
Assume a cost of capital of 10 percent.
c. Should a firm normally have more confidence in answer a or answer b?
12-10. Solution:
Diaz Camera Company
a. Payback Method
Payback for Project A Payback for Project B
b. Net Present Value Method
Project A
Year Cash Flow PVIF at 10% Present Value
1 $6,000 .909 $ 5,454
Chapter 12: The Capital Budgeting Decision
12-10
12-10. (Continued)
Project B
Year Cash Flow PVIF at 10% Present Value
1 $5,000 .909 $ 4,545
2 $3,000 .826 $ 2,478
c. A company should normally have more confidence in answer
11. Internal rate of return (LO4) You buy a new piece of equipment for $11,778, and you
receive a cash inflow of $2,000 per year for 10 years. What is the internal rate of return?
12-11. Solution:
Appendix D
IFA
$11,778
PV 5.889
$2,000
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