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Chapter 24
Capital Budgeting and Investment
Analysis
QUESTIONS
1. Capital budgeting decisions require careful analysis because they are generally
3. Capital budgeting decisions are risky because: (1) the outcomes are uncertain,
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
Financial & Managerial Accounting, 5th Edition
1340
QUICK STUDIES
Quick Study 24-1 (10 minutes)
Quick Study 24-2 (10 minutes)
1. If all else is equal, Investment A would be preferred over Investment B
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.
Quick Study 24-3 (10 minutes)
Quick Study 24-4 (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
Less immediate cash outflow ................................................................
50,000
Net present value .........................................................................................
$ 1,763
*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)
Financial & Managerial Accounting, 5th Edition
1342
Quick Study 24-5 (10 minutes)
Project A: Profitability index = $1,100,000 / 400,000 = 2.75
Quick Study 24-6 (10 minutes)
Quick Study 24-7 (15 minutes)
Year
Net Cash
Flows
Present
Value of
1 at 10%
Present
Value of Net
Cash Flows
1 ...........................................................
$ 45,000
0.9091
$ 40,910
2 ...........................................................
52,000
0.8264
42,973
3 ...........................................................
78,000
0.7513
58,601
Total ....................................................
$175,000
$142,484
Initial investment................................
(135,000)
Net present value ...............................
$ 7,484
Quick Study 24-8 (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)
4
35,000
0.6830
23,905
20, 944
5
35,000
0.6209
21,732
42,676
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 24-9 (15 minutes)
EXERCISES
Exercise 24-1 (20 minutes)
Annual Net
Cumulative
Cash Flows
Cash Flows
Year 1 ....................................................................
$ 60,000
$ 60,000
Year 2 ....................................................................
40,000
100,000
Year 3 ....................................................................
70,000
170,000
Year 4 ....................................................................
125,000
295,000
Year 5 ....................................................................
35,000
330,000
Exercise 24-2 (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
3
54,000
21,600
117,600
32,400
4
32,400
12,960
130,560
19,440
5
19,440
19,440
150,000
0
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
Year 3
50,000
21,600
71,600
202,600
Year 4
37,500
12,960
50,460
253,060
Year 5
100,000
19,440
119,440
372,500
Cost of machine.......................................................................................
$150,000
Paid back in years 1 and 2 ................................................................
131,000
Paid back in year 3 ..................................................................................
$ 19,000
= = 0.265
Payback period = 2 + 0.265 = 2.265 years
Amount paid back in year 3
Net cash flows in year 3
$19,000
$71,600
Exercise 24-3 (20 minutes)
a.
Payback period = = = 2.21 years
where
Annual after-tax income ..........................................................................
$150,000
Plus depreciation* ....................................................................................
85,000
Annual net cash flow ...............................................................................
$235,000
*Annual depreciation = = $85,000
b.
Exercise 24-4 (15 minutes)
Cost of investment
Annual net cash flow
$520,000
$235,000
$520,000 - $10,000
6
Exercise 24-5 (20 minutes)
COMPUTING NET CASH FLOWS FROM NET INCOME
Net income
Cash flows
Sales ................................................................................
$225,000
$225,000
Materials, labor & overhead ..........................................
120,000
120,000
Depreciation ................................................................
30,000
Selling and administrative ............................................
22,500
22,500
Pretax income ................................................................
52,500
Income taxes (30%) .......................................................
15,750
15,750
Net income ................................................................
$ 36,750
Net cash flows ................................................................
$ 66,750
2. Accounting rate of return = = 20.42%
*Average investment
Cost ................................................................
$360,000
Salvage ............................................................
0
Sum ................................................................
$360,000
Average (Sum/2) ..............................................
$180,000
Exercise 24-6 (20 minutes)
Annual
Net Cash
Flows
Present
Value of
Annuity at
8%
Present
Value of
Net Cash
Flows
Years 1 through 6.................................................
$ 66,750
4.6229
$ 308,579
Amount to be invested ................................
(360,000)
Net present value of investment ........................
$ (51,421)
Based on this net present value analysis, the investment is not acceptable.
$360,000
$66,750
$36,750
$180,000*
Exercise 24-7 (35 minutes)
1.
PROJECT C1
Net Cash
Flows
Present
Value of 1
at 12%
Present
Value of Net
Cash Flows
Year 1 ................................................................
$ 12,000
0.8929
$ 10,715
Year 2 ................................................................
108,000
0.7972
86,098
Year 3 ................................................................
168,000
0.7118
119,582
Totals ................................................................
$288,000
$216,395
Amount invested ..................................................
(228,000)
Net present value .................................................
$ (11,605)
PROJECT C2
Net Cash
Flows
Present
Value of 1
at 12%
Present
Value of Net
Cash Flows
Year 1 ................................................................
$ 96,000
0.8929
$ 85,718
Year 2 ................................................................
96,000
0.7972
76,531
Year 3 ................................................................
96,000
0.7118
68,333
Totals ................................................................
$288,000
$230,582
Amount invested ..................................................
(228,000)
Net present value .................................................
$ 2,582
PROJECT C3
Net Cash
Flows
Present
Value of 1
at 12%
Present
Value of Net
Cash Flows
Year 1 ................................................................
$180,000
0.8929
$160,722
Year 2 ................................................................
60,000
0.7972
47,832
Year 3 ................................................................
48,000
0.7118
34,166
Totals ................................................................
$288,000
$242,720
Amount invested ..................................................
(228,000)
Net present value .................................................
$ 14,720
Analysis and Interpretation: Both Project C2 and C3 yield a positive net
present value. Accordingly, both C2 and C3 are acceptable investments.
Exercise 24-7 (Continued)
2. INTERNAL RATE OF RETURN VS. NET PRESENT VALUE FOR C2
3. INTERNAL RATE OF RETURN FOR PROJECT C2
(i) Present value factor = Amount invested / Net cash flows
Financial & Managerial Accounting, 5th Edition
1350
Exercise 24-8 (20 minutes)
PROJECT A
Net Cash
Flows
Present
Value of 1
at 10%
Present
Value of Net
Cash Flows
Year 1 ................................................................
$ 40,000
0.9091
$ 36,364
Year 2 ................................................................
56,000
0.8264
46,278
Year 3 ................................................................
80,295
0.7513
60,326
Year 4 ................................................................
90,400
0.6830
61,743
Year 5 ................................................................
65,000
0.6209
40,359
Totals ................................................................
$331,695
245,070
Amount invested ..................................................
(160,000)
Net present value .................................................
$ 85,070
PROJECT B
Net Cash
Flows
Present
Value of 1
at 10%
Present
Value of Net
Cash Flows
Year 1 ................................................................
$ 32,000
0.9091
$ 29,091
Year 2 ................................................................
50,000
0.8264
41,320
Year 3 ................................................................
66,000
0.7513
49,586
Year 4 ................................................................
72,000
0.6830
49,176
Year 5 ................................................................
24,000
0.6209
14,902
Totals ................................................................
$244,000
184,075
Amount invested ..................................................
(105,000)
Net present value .................................................
$ 79,075
Project A’s profitability index = $85,070 / 160,000 = 0.5317
Exercise 24-9A (20 minutes)
Using Excel, Project A (B) has an internal rate of return of 26.96 (35.00%).
Project A Project B
A
B
C
D
1
Initial investment
-160000
-105000
2
Annual cash flows,
end of period
3
1
40000
32000
4
2
56000
50000
5
3
80295
66000
6
4
90400
72000
7
5
65000
24000
8
Formula for IRR
=IRR(C1:C7)
=IRR(D1:D7)
Exercise 24-10 (15 minutes)
1. Recovery time computation
Payback Period
Break-Even Time
$90,000 / $35,000 = 2.57 years
3.2 years (see answer for QS 24-8)
2. The advantage of break-even time is that it considers the time value of
3. When (1) the interest rate is very low, 1% for example, and (2) the
PROBLEM SET A
Problem 24-1A (50 minutes)
Part 1
Part 2
Net
Net Cash
Income
Flow
Expected annual sales of new product ..................
$1,840,000
$1,840,000
Expected costs of new product
Direct materials ......................................................
(480,000)
(480,000)
Direct labor .............................................................
(672,000)
(672,000)
Overhead excluding depr. on new asset .............
(336,000)
(336,000)
Depreciation on new asset ...................................
(115,000)
Selling and administrative expenses ...................
(160,000)
(160,000)
Income before taxes .................................................
77,000
Income taxes (30%) ..................................................
(23,100)
(23,100)
Net income ................................................................
$ 53,900
Net cash flow* ...........................................................
$ 168,900
* Alternatively, annual net cash flow can be computed as
Net income + Depreciation = $53,900 + $115,000 = $168,900
Part 3
Problem 24-1A (Continued)
Part 4
* Average investment
Asset cost ..................................................................................
$480,000
Final year’s book value .............................................................
20,000
Sum ............................................................................................
$500,000
Average (Sum /2) ................................................................
$250,000
Part 5
Present Value of Net Cash Flows
Present
Present
Net Cash
Value of
Value of Net
Flows
1 at 7%
Cash Flows
Year 1 ..........................................................
$168,900
0.9346
$ 157,854
Year 2 ..........................................................
168,900
0.8734
147,517
Year 3 ..........................................................
168,900
0.8163
137,873
Year 4* .........................................................
188,900
0.7629
144,112
Totals ..........................................................
$695,600
587,356
Amount invested ........................................
(480,000)
Net present value .......................................
$ 107,356
* Year 4’s cash flow includes the $20,000 salvage value.
$250,000*
