Chapter 12 – Strategy and the Analysis of Capital Investments
SUM = $ 159,900 $ 115,833
12-58 (Continued-2)
Alternatively:
a) For 8%: ($14,545 × 10.935) + (0.116 × $7,273) = $159,900
b) For 12%: ($14,545 × 7.943) + (0.042 × $7,273) = $115,833
Estimated NPV of Proposed Investment (@ 8% discount rate):
Net initial investment outlay, time 0 = ($1,000,000)
Plus: PV of after-tax rental revenues (11.258 × $100,800) = $1,134,806
b. If the discount rate was 12% (rather than 10%), the estimated NPV of the project is
($202,134), as follows:
Net initial investment outlay, time 0 = ($1,000,000)
Plus: PV of after-tax rental revenues (8.055× $100,800) = $811,944
Summary:
Discount Rate NPV
8.00% $113,137
10.00% ($66,917)
12.00% ($202,134)
3. Additional factors to be considered before investing in the apartment complex:
Alternative investment opportunities (rather than the proposed investment)?
Sensitivity of investment decision (i.e., accept or reject) with respect to:
oVolume (occupancy) assumption?
oOut-of-pocket (cash) operating expenses?
Availability of any investment tax credits?
properties?
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Chapter 12 – Strategy and the Analysis of Capital Investments
12-59 Environmental Cost Management (60 minutes)
1.
Solvent System
Present
Value Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11
Initial investment $400,000
After-tax paint cost (1) $228,000 $228,000 $228,000 $228,000 $228,000 $228,000 $228,000 $228,000 $228,000 $228,000 0
Discount factor (12%) 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287
Present value 3,360,365 532,090 464,867 419,229 377,411 338,552 304,227 271,817 242,951 217,087 193,640 (1,506)
Total cost $3,760,365
Powder System
Initial investment $1,200,000
After-tax paint cost(4) $240,000 $240,000 $240,000 $240,000 $240,000 $240,000 $240,000 $240,000 $240,000 $240,000 0
Depreciation (MACRS) 120,000 216,000 172,800 138,240 110,640 88,440 78,600 78,600 78,720 78,600 39,360
Tax saving on depreciation 48,000 86,400 69,120 55,296 44,256 35,376 31,440 31,440 31,488 31,440 15,744
Net after-tax cash costs 192,000 153,600 170,880 184,704 195,744 204,624 208,560 208,560 208,512 208,560 (15,744)
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Chapter 12 – Strategy and the Analysis of Capital Investments
12-59 (Continued)
Notes:
(1) Annual after-tax paint cost, solvent system = $0.19/unit × 2,000,000 units/year
(2) MACRS depreciation rates, 10-year property (from text Exhibit 12.4):
Year Rate
1 10.00%
2 18.00%
* First year switching to SL method
(3) Additional environmental costs, Solvent Paint System:
(4) Annual after-tax paint cost, Powder Paint System = $0.20/unit × 2,000,000
2. Based solely on financial considerations, the maximum the company should spend
on the Powder-Based System = original estimate + difference in PVs of costs (from
Year Rate
6 7.37%
7 6.55%*
8 6.55%
Item Annual Cost
Pit cleaning $12,000
Waste disposal 549,000
Superfund Fee 3,177
Worker training 3,000
Insurance 10,000
Amortization of air-emission permit 200
Air-emission fee 1,115
Chapter 12 – Strategy and the Analysis of Capital Investments
12-60 Research Assignment, Strategy (50-60 Minutes)
This assignment pertains to the following article: Clayton M. Christensen, Stephen P.
Kaufman, and Willy C. Shih, “Innovation Killers: How Financial Tools Destroy Your
Capacity to Do New Things,” Harvard Business Review (January 2008), pp. 98-105.
The article focuses on bias against innovation that is attributable to the misuse of
certain financial tools. In fact, they conclude (p. 104) that “managers in established
corporations use analytical methods that make innovation investments extremely
difficult to justify.” The authors point to the following three “misguided applications” of
financial tools: (1) discounted cash flow (DCF) and net present value (NPV) to evaluate
investment opportunities causes managers to underestimate the real returns and
benefits of proceeding with investments in innovation. (2) The way that fixed and sunk
costs are considered when evaluating future investments confers an unfair advantage
on challengers and shackles incumbent firms that attempt to respond to an attack. (3)
The emphasis on earnings per share as the primary driver of share price and hence of
shareholder value creation, to the exclusion of almost everything else, diverts resources
away from investments whose payoff lies beyond the immediate horizon.
1. According to the authors of the article, how does the use of DCF tools by
managers in practice bias against innovation? What solution do the authors
propose to counter this problem?
While not disputing the underlying mathematics of the discounting process that lies at
the heart of DCF methods such as NPV, the authors assert two implementation errors
on the part of decision-makers:
(1) The “DCF Trap:” some analysts (erroneously) assume a status quo competitive
position in their analysis of an investment project. That is, they extrapolate the
current market share and profitability of the company, without recognizing the
potential for erosion of both over time as competitors invest. As the authors state,
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Chapter 12 – Strategy and the Analysis of Capital Investments
12-60 (Continued-1)
starting-point cash inflow by the amount “r – g,” where r is the discount rate and
g is the assumed growth-rate for the cash inflows from that point forward, into
infinity.)
The authors indicate two errors in the above approach: (1) the mathematics of
the approach amplifies estimation errors associated with near term estimated
cash inflows (because the future stream, to infinity, is a function of the assumed
near-term cash inflows), and (2) the method fails to incorporate the declining
competitive situation discussed above in point #1.
2. Define the terms “fixed costs” and “sunk costs.” According to the authors of
this article, what is the bias against innovation that is created by how some
decision-makers view such costs? What remedies do the authors recommend
for dealing with this problem?
(a) “Fixed costs” are defined as those costs that in the short run do not vary in
response to an underlying activity variable or cost driver. These costs are also
referred to as “capacity-related” costs, since they provide a certain amount of
well.” The example of Nucor and USX steel companies can be used here to more
forcefully illustrate the underlying error of logic regarding the adequacy of current
levels of investment in support of innovation investments. In committing this error,
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Chapter 12 – Strategy and the Analysis of Capital Investments
such managers fail to make the same investments that new entrants and
attackers find to be profitable.
12-60 (Continued-2)
One possibility for dealing with the above-mentioned problem is to view the
competitive not useable life of the assets being contemplated. While the latter is
3. The authors suggest that bias in the evaluation of innovation projects is
caused, as well, by an overemphasis on (short-term) earnings per share
statistics. What is the essence of this argument? What do the authors propose
as a recommendation for addressing this problem?
The authors suggest that many managers focus too narrowly on (short-term)
earnings per share and earnings-per-share growth metrics, under the (misguided)
assumption that these numbers are inherently linked to share price and therefore
shareholder value-creation. In part, this bias may be attributable to the desire to have
have positive long-term value effects, but negative (or at least adverse) effects on
short-term earnings per share results.
To address this problem, the authors suggest the need for a reexamination of the
principal-agent paradigm. This paradigm assumes that in order to align the interests
of principals (shareholders, or shareowners) the rewards to agents (the managers/
decision-makers) need to be linked to long-term share performance. While widely
taught in business schools today, and the underlying basis for structuring the
incentive-compensation plans for many executives, the authors suggest the need to
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