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Chapter 25 - Capital Budgeting and Managerial Decisions
Chapter 25
Capital Budgeting and Managerial
Decisions
QUESTIONS
1. Capital budgeting decisions require careful analysis because they are generally
the most difficult and risky decisions that management faces.
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
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9. The internal rate of return is the rate that produces a net present value of zero. If
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 out-of-pocket cost requires a current outlay of cash. An opportunity cost is
12. Sunk costs are irrelevant because they remain the same whether the product is
sold in its present condition or processed further.
13. There are virtually no incremental costs associated with shipping the additional
iPod. The company’s employees would not receive any additional compensation
14. Management could use one of the following common methods to evaluate the
15. The company might be willing to sell the units internationally if (a) the company
has excess capacity, (b) the incremental costs of manufacturing and selling the
units are less than $5,000 each, which it appears to be at $4,000 variable cost per
unit (c) the international sales won’t reduce domestic sales, and (d) the
international buyer is unwilling to pay more than $5,000.
QUICK STUDIES
Quick Study 25-1 (5 minutes)
Payback period of investment = $27,000 / $9,000 = 3.0 years
Quick Study 25-2 (5 minutes)
Net present value of investment
Present value of four $9,000 cash inflows ($9,000 x 3.1699*)..................$28,529
Less immediate cash outflow..................................................................... 27,000
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Chapter 25 - Capital Budgeting and Managerial Decisions
Net present value.........................................................................................$ 1,529
*Present value factor from Table B.3:
3.1699 = Present value of an annuity of 1, where n = 4, i = 10%
Quick Study 25-3 (5 minutes)
than the hurdle rate of 10%, the company should make the investment.
Quick Study 25-4 (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:
i. The present value of cash flows from Investment B might greatly
exceed the present value of cash flows from Investment A.
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Education.
Chapter 25 - Capital Budgeting and Managerial Decisions
Quick Study 25-7 (5 minutes)
Accounting rate of return = $1,950 / [($45,000 + $6,000)/2] = 7.65%
Quick Study 25-8 (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
Quick Study 25-9 (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 of cash inflows..................................................................... 51,763
Quick Study 25-10 (10 minutes)
Project A: Profitability index = $1,100,000 / $400,000 = 2.75
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Education.
Chapter 25 - Capital Budgeting and Managerial Decisions
Project B: Profitability index = $6,000,000 / $4,000,000 = 1.50
Higher values of the profitability index indicate a better project, so on the
basis of this measure the company should select Project A.
Quick Study 25-11 (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
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 25-13 (10 minutes)
Present value factor = Amount invested = $47,947 = 2.2832 (rounded)
Net cash flows $21,000
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Chapter 25 - Capital Budgeting and Managerial Decisions
Quick Study 25-14 (10 minutes)
Net present value of investment
Present value of three $21,000 cash inflows ($21,000 x 2.5771*)............$54,119
Less immediate cash outflow..................................................................... 47,947
Net present value.........................................................................................$ 6,172
*Present value factor from Table B.3:
2.5771 = Present value of an annuity of 1, where n = 3, i = 8%
Quick Study 25-15 (5 minutes)
Quick Study 25-16 (15 minutes)
INCREMENTAL INCOME FROM NEW BUSINESS
Sales (750 units @ $250).............................................................................$ 187,500
The company should accept the offer for new business as it increases
income by $25,000.
Quick Study 25-17 (15 minutes)
Incremental cost analysis
Costs of purchasing
Cost to purchase Product B........................................................................$5.00
Revenue loss from reduced price ($13.50 - $12.00).................................. 1.50
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Chapter 25 - Capital Budgeting and Managerial Decisions
Analysis: Kando Co. should continue to manufacture and sell Product A.
Quick Study 25-18 (10 minutes)
(Per unit) Make Buy
Direct materials.................................................... $2.25 ----
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Chapter 25 - Capital Budgeting and Managerial Decisions
Quick Study 25-19 (15 minutes)
Quick Study 25-20 (15 minutes)
Sell as is
Process
further
Incremental revenue............................................ $67,500 $468,750*
Incremental costs ($250 x 1,250)........................ ---- (312,500)
Quick Study 25-21 (5 minutes)
(Per unit) Sell as is
Process
further
Incremental revenue............................................ $15.00 $21.00
Incremental costs................................................. ---- (8.00)
Quick Study 25-22 (15 minutes)
X Y
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Chapter 25 - Capital Budgeting and Managerial Decisions
Contribution margin per production hour.............................$10.00 $12.00
Sales mix analysis: Since Excel Memory can sell all it can produce of both
products, it should allocate all of its production capacity to Product Y. This
is because Y yields a $12 contribution margin per production hour (versus
$10 for X).
Quick Study 25-23 (15 minutes)
Avoidable Unavoidable
Expenses Expenses
Cost of goods sold............................................... $56,000 ----
Direct expenses.................................................... 9,250 $1,250
The division should not be eliminated because its sales of $72,000 are
greater than its avoidable expenses of $71,720.
Quick Study 25-24 (5 minutes)
Avoidable
Expenses
Variable costs....................................................... $145,000
Direct fixed costs................................................. 30,000
Indirect expenses (40% avoidable).................... 20,000
Quick Study 25-25 (10 minutes)
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Chapter 25 - Capital Budgeting and Managerial Decisions
INCREMENTAL INCOME FROM REPLACING MACHINE
Cost to buy new machine............................................................................$(112,500)
Cash received to trade in old machine...................................................... 60,000
Quick Study 25-26 (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)
3 35,000 0.7513 26,296 (2,961)
reasonable estimate would be approximately 3.2 years (or 3 years, 2
months) for break-even time.
Quick Study 25-27 (15 minutes)
1. Payback period of investment = €80,000,000 / €16,000,000 = 5 years
2. Present value of cash inflows (€16,000,000 x 5.7466) €91,945,600
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