CHAPTER 26
CAPITAL BUDGETIN
G
Brief Learning
Exercises Topic Objectives Skills
B. Ex. 26.1 Understanding payback period 26-3 Analysis
B. Ex. 26.2 Use of return on investment 26-3 Analysis
B. Ex. 26.3 Comparing NPV and required rate of return 26-3, 26-4 Analysis
B. Ex. 26.4 Net present value computations 26-3 Analysis
B. Ex. 26.5 Computations for payback period 26-3 Analysis
B. Ex. 26.6 Capital investment challenges 26-1, 26-2 Analysis, judgment
B. Ex. 26.7 Net present value and required rate of return 26-3, 26-4 Analysis, judgment
B. Ex. 26.8 Capital budgeting behaviors 26-5 Analysis, judgment
B. Ex. 26.9 Net present value analysis 26-3 Analysis
B. Ex. 26.10 Nonfinancial investment concerns 26-2 Analysis, communication,
judgment
Learning
Exercises Topic Objectives Skills
26.1 Accounting terminology 26-1–26-5 Analysis
26.2 Payback period 26-1–26-3 Analysis, communication,
judgment
26.3 Understanding return on average investment 26-1, 26-3 Analysis
26.4 Discounting cash flows 26-3 Analysis
26.5 Understanding net present value relationships 26-3 Analysis
26.6 Analyzing a capital investment proposal 26-1, 26-3 Analysis
26.7 Analyzing capital investment proposal 26-1–26-4 Analysis, communication,
judgment
26.8 Analyzing capital investment proposal 26-1, 26-3 Analysis
26.9 Competing investment proposals 26-1, 26-2,
26-5 Analysis, communication,
judgment
26.10 Replacing existing equipment 26-1–26-3,
26-5 Analysis, communication,
judgment
26.11 Gains and losses on sale of equipment 26-3 Analysis
26.12 Depreciation effects on cash flows 26-3 Analysis
OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL
THINKING CASES
Learning
Exercises Topic Objectives Skills
26.13 Net present value in a not-for-profit 26-2, 26-3 Analysis, communication,
judgment
26.14 NPV of uneven cash flows 26-3 Analysis
26.15 Real World: Home Depot’s present value of
store closing costs 26-1–26–3 Analysis, communication,
judgment , research
Problems Learning
Sets A, B Topic Objectives Skills
26.1 A,B Capital budgeting and determination of
annual net cash flow 26-1–26–4 Analysis
26.2 A,B Analyzing capital investment proposals 26-1–26–4 Analysis, communication,
judgment
26.3 A,B Analyzing capital investment proposals 26-1–26–4 Analysis, communication,
judgment
26.4 A,B Capital budgeting using multiple models 26-1–26–4 Analysis, communication,
judgment
26.5 A,B Capital budgeting using multiple models 26-1–26–4 Analysis, communication,
judgment
26.6 A,B Analyzing a capital investment proposal 26-3 Analysis
26.7 A,B Considering financial and nonfinancial
factors 26-1–26-4 Analysis, communication,
judgment
26.8 A,B Analyzing competing capital investment
proposals 26-1–26-4 Analysis, communication,
judgment
26.9 A,B Analyzing competing capital investment
proposals 26-1–26-5 Analysis, communication,
judgment
Critical Thinking Cases
26.1 How much is that laser in the window? 26-2–26-4 Analysis, communication,
judgment
26.2 Dollars and cents versus a sense of ethics 26-1–26-5 Analysis, communication,
research
26.3 International investments in outsourcing 26-1, 26-2,
26-5 Analysis, communication,
judgment
26.4 Real World: Red Robin Gourmet 26-5 Analysis, communication
Burgers judgment
(Ethics, fraud and corporate governance)
DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES
Problems (Sets A and B)
26.1 A,B To
y
in
g
with Nature/Monster To
y
s30 Strong
Covers incremental analysis and three basic capital budgeting
techniques in a single problem.
26.2 A,B Hibbin
g
Technolo
gy
/Vir
g
inia Technolo
gy
25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.3 A,B Welsh Industries/Jason E
q
ui
p
ment Co. 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.4 A,B Maren
g
o/Samba 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.5 A,B V.S. Yo
g
urt/I.C. Cream 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.6 A,B Pathways Appliance Company/Cafield Appliance Company 30 Strong
Prepare a schedule showing the estimated incremental net income from
proposed introduction of a new product. Compute annual cash flow,
payback period, return on average investment, and net present value of
the investment proposal.
26.7 A,B Doctors 40 Strong
Students must determine whether it is profitable for several doctors to
invest their money in an expensive piece of testing equipment. Requires
financial analysis and consideration of nonfinancial aspects of their
decision.
Below are brief descriptions of each problem and case. These descriptions are accompanied by the estimated
time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the
partially filled-in working papers.
26.8 A,B Jefferson Mountain/Jackson Mountain 50 Strong
A small ski resort must decide between alternative investment
proposals. Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
26.9 A,B Sonic, Inc./Boom, Inc. 45 Strong
A software company is trying to decide how to market their software.
Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
Critical Thinking Cases
26.1 Metro Printers
The Case of the Costl
y
Laser 25 Stron
g
Compute the net present value of a proposal to replace existing
equipment with new, more efficient equipment. The sale of the
existing equipment will involve a large loss. Students are asked to
comment on the relevance of this sunk cost.
26.2 Grizzl
y
Communit
y
Hos
p
ital 60 Stron
g
A small community hospital considers a major capital investment in
a regional kidney center. Students are asked to analyze financial and
nonfinancial information relevant to the decision, explore
alternative uses of resources, and help the hospital define its role.
26.3 International Investments in Outsourcing 20 Medium
The cash flows associated with offshore investments are identified.
Ethical considerations of asking domestic employees to train their
international replacements are considered.
26.4 Red Robin Gourmet Burgers 30 Medium
Ethics, Fraud & Cor
p
orate Governance
Governance violations at Red Robin Gourmet Burgers leads to
capital budgeting conflicts of interest.
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1.
Capital budgeting is the process of planning and evaluating investments in plant assets. Capital
9.
10.
11.
13.
14.
If an investment with no salvage value has a payback period that exceeds its estimated life, the
investment’s net present value will be negative. If the payback period exceeds the asset’s life,
If an investment proposal has a net present value of zero, the expected rate of return is equal to
the discount rate.
An investment’s contribution to income is not the same as its incremental cash flow because
One way to ensure that employee estimates of the costs and benefits of capital investments are
not overly optimistic or pessimistic is to implement a system for auditing capital budget
decisions. With an audit system in place, employees will be aware that their estimates will be
Some capital investment proposals which may favor nonfinancial factors include a pollution
control systems, new factory lighting, an employee health club, and an employee child care
Cost of investment (98,000)
Net present value of proposed investment 44,309$
B. Ex. 26.5 Amount to be invested $60,000
Est. annual net cash flows $80,000 – $65,000
B. Ex. 26.6
SOLUTIONS TO BRIEF EXERCISES
= = 4 years
The estimated cash flows of replacement equipment often is relatively easy to estimate
because the company has experience with similar of assets. Thus, replacing a fleet of
trucks, where 20% of the fleet is replaced each year so that over a five year period all
trucks have been replaced, is the type of investment that is easy to estimate cash flows.
B. Ex. 26.6
(continued)
Alternatively, new technology is inherently difficult to estimate. For example, when
VCRs, DVD players, or I-Pods were first introduced to the market, the prices were
set fairly high because manufacturers could not estimate demand. As demand grew
SOLUTIONS TO EXERCISES
Ex. 26.1 a.
b.
c.
Ex. 26.2 a.
b.
The payback period for the Toledo Tools machine is computed as follows:
Incremental analysis
Sunk cost
Capital budgeting
If the Akron Industries machine has a payback period of 66 months (or 5.5 years),
its cost can be computed as follows: