Chapter 24
Capital Budgeting and Investment
Analysis
QUESTIONS
1. Capital budgeting decisions require careful analysis because they are generally
2. Capital budgeting is the process of planning the acquisition or sale of plant
assets.
3. Capital budgeting decisions are risky because: (1) the outcomes are uncertain,
4. The payback period ignores both the present value of cash flows and all cash
flows after the payback period.
5. A shorter payback period is desirable because management prefers to reduce
the risk that the investment might not be profitable over the long run. As a result
6. If net income is earned evenly throughout each year and straight-line
7. When the present value of expected net cash flows, discounted at 10%, exceeds
the amount invested it indicates that the expected rate of return on the
8. Receiving $100 one year from today is worth less than $100 today because a
return can be earned on a $100 investment during the year. If $100 to be
9. The internal rate of return is the rate that produces a net present value of zero. If
the internal rate of return is higher than the company’s hurdle rate, it means that
the net present value of the project is positive, and the company should make
the investment.
10. Accelerated depreciation produces larger tax deductions and lower tax
payments in the early years of an asset’s life compared with straight-line
11. An investment of this nature in technology is risky for many reasons: (1) Samsung
cannot be 100% certain of the costs and benefits of such a system; (2) there is a
12. Some of the costs and benefits are: cost of the new equipment; cost savings from
operating the new equipment over the life of the equipment; training costs for
workers. All of these cash flows need to be evaluated using Google’s hurdle rate of
return.
13. Apple management could use one of the following common methods to evaluate the
Financial and Managerial Accounting, 6th Edition
1386
QUICK STUDIES
Quick Study 24-1 (5 minutes)
Payback period of investment = $27,000 / $9,000 = 3.0 years
Quick Study 24-2 (5 minutes)
Net present value of investment
Present value of four $9,000 cash inflows ($9,000 x 3.1699*)…..…..……..$28,529
Quick Study 24-3 (5 minutes)
Searching the four-year row in Table B.3 for a present value factor of 3.00
shows that the internal rate of return is above 12%. Since 12% is greater
than the hurdle rate of 10%, the company should make the investment.
Quick Study 24-4 (10 minutes)
1. If all else is equal, Investment A would be preferred over Investment B
because of A’s shorter payback period.
2. However, if the investments are different, then there are at least four
reasons why Investment B might be preferred over Investment A:
A.
iv. The growth potential of Investment B might be much greater than that
for Investment A.
Quick Study 24-5 (10 minutes)
Quick Study 24-6 (10 minutes)
Accounting rate of return = $20,000 / [($280,000 + $30,000)/2] = 12.90%
Quick Study 24-7 (5 minutes)
Quick Study 24-8 (15 minutes)
Net present value of investment*
Present value of three $14,950 cash inflows ($14,950 x 2.2832)…………..$34,134
Present value of $6,000 at end of three years ($6,000 x 0.6575)………….. 3,945
Present value of cash inflows………………………………..……………….………... 38,079
*Present value factors from tables at the end of Appendix B:
Financial and Managerial Accounting, 6th Edition
Quick Study 24-9 (15 minutes)
Net present value of investment*
Present value of seven $10,000 cash inflows ($10,000 x 4.8684)....…..…$48,684
Present value of $6,000 at end of seven years ($6,000 x 0.5132)............ 3,079
*Present value factors from tables at the end of Appendix B:
4.8684 = Present value of an annuity of 1, where n = 7, i = 10% (from Table B.3)
0.5132 = Present value of 1, where n = 7, i = 10% (from Table B.1)
Quick Study 24-10 (10 minutes)
Project A: Profitability index = $1,100,000 / $400,000 = 2.75
basis of this measure the company should select Project A.
Quick Study 24-11 (15 minutes)
Net Cash
Flows
Present
Value of
1 at 12%
Present
Value of
Net Cash
Flows
Year 1……………………………………………………………$100,000 0.8929 $ 89,290
Year 2……………………………………………………………90,000 0.7972 71,748
Year 3…………………………………………………………… 75,000 0.7118 53,385
Quick Study 24-12 (15 minutes)
Net Cash
Flows
Present
Value of
1 at 12%
Present
Value of
Net Cash
Flows
Year 1……………………………………………………………$100,000 0.8929 $ 89,290
Year 2……………………………………………………………90,000 0.7972 71,748
Year 3…………………………………………………………… 95,000 0.7118 67,621
Quick Study 24-13 (10 minutes)
Searching the three-year row in Table B.3 for a present value factor of
2.2832 shows that the internal rate of return is 15%.
Quick Study 24-14 (10 minutes)
Net present value of investment
Present value of three $21,000 cash inflows ($21,000 x 2.5771*)....…..…$54,119
Less immediate cash outflow…………..………………..……..…..………..…..…... 47,947
Financial and Managerial Accounting, 6th Edition
Quick Study 24-15 (15 minutes)
Year Cash flows
Present value
of 1 at 10%
Present value of
cash flows
Cumulative
present value of
cash flows
0 $(90,000) 1.0000 $(90,000) $(90,000)
1 35,000 0.9091 31,819 (58,181)
2 35,000 0.8264 28,924 (29,257)
The break-even time point occurs in the 2nd month of the 4th year
[computed as ($2,961 / $23,905) x 12 = 1.5 months]. Therefore, a
reasonable estimate would be approximately 3.2 years (or 3 years, 2
months) for break-even time.
Quick Study 24-16 (15 minutes)
1. Payback period of investment = €80,000,000 / €16,000,000 = 5 years
EXERCISES
Exercise 24-1 (20 minutes)
Annual Net Cumulative
Cash Flows Cash Flows
Year 3…………………………………………………………... 70,000 170,000
Year 4…………………………………………………………... 125,000 295,000
Cost of investment………….………………..……………………………….…....$180,000
Part of year = = = 0.08
$10,000
$125,000
Amount paid back in year 4
Net cash flow in year 4
Exercise 24-2 (20 minutes)
Net Cash
Flows
Present
Value of
1 at 10%
Present
Value of
Net Cash
Flows
Year 1……………………………………………………………$ 60,000 0.9091 $ 54,546
Year 2……………………………………………………………40,000 0.8264 33,056
The company should accept the investment, as it has a positive net present
value.
Exercise 24-3 (15 minutes)
ANNUAL CASH FLOWS
Net
Income Depreciation*
Net Cash
Flow
Cumulative
Cash Flow
Year 1 $ 10,000 $30,000 $ 40,000 $ 40,000
Year 2 25,000 30,000 55,000 95,000
*($150,000 – $0)/5 = $30,000
Cost of machine….……..……..……..……..…..……..……..……..…..……….$150,000
Paid back in years 1 and 2…..……..……..…………..……..…………..…… 135,000
Paid back in year 3………..……..……..…………..…….……..……………....$ 15,000
Payback period = 2 + 0.188 = 2.188 years
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Solutions Manual, Chapter 24
$15,000
$80,000
Amount paid back in year 3
Net cash flows in year 3
1393
Exercise 24-4 (30 minutes)
COMPUTATION OF ANNUAL DEPRECIATION EXPENSE
Double-declining balance rate = (100% / 5) x 2 = 40%
Annual Depr.
Beginning (40% of Accum. Depr. Ending
Year Book Value Book Value) at Year-End Book Value
1 $150,000 $60,000 $ 60,000 $90,000
2 90,000 36,000 96,000 54,000
ANNUAL CASH FLOWS
Net
Income Depreciation
Net Cash
Flow
Cumulative
Cash Flow
Year 1 $ 10,000 $60,000 $ 70,000 $ 70,000
Year 2 25,000 36,000 61,000 131,000
Cost of machine….……..……..……..……..…..……..……..……..…..……….$150,000
Paid back in years 1 and 2…..……..……..…………..……..…………..…… 131,000
Paid back in year 3………..……..……..…………..…….……..……………....$ 19,000
Payback period = 2 + 0.265 = 2.265 years
Financial and Managerial Accounting, 6th Edition
$19,000
$71,600
Amount paid back in year 3
Net cash flows in year 3