978-0133058789 Chapter 11 Part 1

CHAPTER 11

COVERAGE OF LEARNING OBJECTIVES

LEARNING OBJECTIVE

FUNDA-

MENTAL

ASSIGN–

MENT

MATERIAL

CRITICAL

THINKING

EXERCISES

AND

EXERCISES

PROBLEMS

CASES,

EXCEL,

COLLAB., &

INTERNET

EXERCISES

LO1: Describe capital

budgeting decisions and

use the net present value

(NPV) method to make

such decisions.

A1, A2, B1

B2

26, 29, 30

31, 32, 33

34, 35, 36

37, 38, 39

40, 41

51, 52, 53

54, 55, 56

62, 64

68,69, 70, 71,

73, 75

LO2: Use sensitivity

analysis to evaluate effect

of changes in predictions.

40, 41

68, 71

LO3: Calculate the NPV

difference between two

projects using both the

total project and

differential approaches.

51, 52

LO4: Identify relevant

cash flows for NPV

analyses.

25, 27

51, 52, 53

54, 55, 56

57, 60, 61

68, 69, 70, 74

LO5: Compute the after-

tax net present values of

projects.

A3, A4, B3

B4

42, 43, 44

45

57, 58, 59

60, 64, 65, 66

70, 72

LO6: Explain the after-tax

effect of cash of disposing

of assets.

A5, B5

28

58, 59

71

LO7: Use the payback

model and the accounting

rate-of-return model and

compare them with the

NPV model.

40, 46, 47, 48

61, 62

73

LO8: Reconcile conflict

between using NPV model

for making a decision and

using accounting income

for evaluating the related

performance.

63

LO9: Compute the impact

of inflation on a capital-

budgeting project.

49, 50

66, 67

450

CHAPTER 11

Capital Budgeting

11-A1 (15-25 min.) Answers are printed in the text at the end of the assignment

material.

11-A2 (20-30 min.) This is a straightforward exercise.

1 & 2. The model indicates that the computers should be acquired because the net

present value is positive.

1. The model indicates that the servers should not be acquired.

Sketch of Cash Flows

12% Total (in thousands)

Discount PV 0 1 2 3

2. The computers should be acquired. The net present value rises, and now it is

positive:

After-tax impact of disposal on cash: .60 × ($90,000 – 0) $ 54,000

3. This requirement demonstrates that the choice of a discount rate often is critical.

Applying an 8% discount factor:

11-A4 (25-30 min.)

1. Cash effects of operations:

Before tax annual cash inflow $ 420,000

Taxes @ 45%: 420,000 × .45 189,000

After-tax cash inflow $ 231,000

Present value @ 14%: $231,000 × 5.2161 $1,204,919

2. The 7-year MACRS analysis will apply regardless of the economic life of the

equipment. The only change from requirement 1 will be the added five years of

cash effects from operations:

This change can be incorporated by re-computing the value of the $231,000

after-tax inflow but now for 15 years, and then using that in the calculation:

11-A5 (5-10 min.)

Many students forget to add the cash proceeds to the tax effect. Answers are in

dollars.

(a) Cash sale price 305,000 230,000

453

11-B1 (15-20 min.)

1. Using the right table is essential. Factors for this part are from Table 1:

2. Use Table 2: (a) PV = $50,000 × 3.4651 = $173,255

3. Use Table 2: (a) PV = annual withdrawal × F

$6,000,000 = annual withdrawal × 13.5903

4. Contract Y has the higher present value despite the lower total dollars paid:

Present Value Present Value Present Value

11-B2 (20-30 min.) This is a straightforward exercise.

1 & 2. The model indicates that the equipment should be acquired because the net

present value is positive.

11-B3 (20-30 min.) This is a straightforward exercise.

1. The model indicates that the equipment should not be acquired.

Sketch of Cash Flows

14% Total (in thousands)

Discount PV 0 1 2 3 4 5

2. The equipment should not be acquired. The net present value is negative.

After-tax impact of disposal on cash:

3. Applying 10% discount factors:

$130,000 × (1 – .40) × 3.7908 $ 295,682

$80,000 × .40 × 3.7908 121,306

455

11-B4 (25-30 min.)

1. See Exhibit 11-B4 on the following page for requirement 1.

2. The major reason for this requirement is to underscore the fact that the present

value of the depreciation tax savings is unchanged regardless of the length of the

economic life of the asset.

PV @ 10% of 6 years of $41,250 4.3553 × 41,250 $ 179,656

11-B5 (5-10 min.)

Many students forget to add the cash proceeds to the tax effect. Answers are in

dollars.

1. 2.

(a) Cash sale price 35,000 85,000

456

EXHIBIT 11-B4

(Dollar amounts in thousands) Total

1. 10% PV Sketch of Cash Flows (in dollars)

Discount @ 10% 0 1 2 3 4 5 6

Factor ($000)

Cash effects on operations,

$75 × (1 – .45) 3.7908 156.371 <––– 41.25 41.25 41.25 41.25 41.25

11-1 The accountant has a limited role in the project identification phase. In the

selection phase, accountants provide information for predicting cash inflows and

11-3 No. A higher required rate of return reduces the present value of future cash

11-4 No. It is true that the DCF model assumes certainty and perfect capital markets.

11-5 Yes, double counting does occur if depreciation expense is considered

11-6 No. The IRR and NPV models generally make the same decision. Suppose we

11-7 The real-options model recognizes the value in allowing investment in stages –

that is, contingent investments. If managers can adjust the investment after gaining the

11-8 Sensitivity analysis is especially appropriate for organizations that do not have

11-9 The differential approach should lead to the same choice between alternatives as

11-10 The NPV model is appropriate for all types of investments. However, with

some types of investments, such as those in advanced technology, NPV must be carefully

11-11 The marginal tax rate is the rate paid on additional amounts of pretax income.

In contrast, the average tax rate is the total taxes paid divided by the total pretax income.

11-12 No. Two sets of books are appropriate. The objectives of tax reporting and

shareholder reporting differ; therefore, the rules for reporting to each differ. If companies

11-13 Tax avoidance is the achieving of a reduction in income tax payments through

11-15 Companies should prefer accelerated rather than straight-line depreciation for

11-16 Yes. Two streams may be identified: (a) inflows from operations and (b)

11-17 Because of the time value of money, the earlier a company takes tax deductions

and thereby saves taxes, the larger the present value of the tax savings.

11-18 Yes. MACRS treats assets as if they were purchased at midyear, so they have

depreciation effects for one tax year more than the number of years of their depreciable

11-20 It is useful to learn the “payback” and “accounting rate-of-return” methods of

capital budgeting because they are widely used today. In addition, the payback method

11-21 The basic flaw in the payback method is that it does not compare the total

11-22 If a company makes capital-budgeting decisions using DCF and evaluates

performance using accrual accounting numbers, a conflict may arise. Often accrual

value.

11-23 The three components of the market or nominal interest rate are: 1) risk-free

element, or pure rate of interest, 2) business-risk element, and 3) inflation element.

11-24 The correct analysis under inflation (a) uses a required rate that includes an

11-25 It is difficult to predict the cash flows to be received from an investment in

research and development (R&D) because there is so much uncertainty involved. The

11-26 The net present value of an investment project represents the increase (or

decrease) in the value of the firm from investing in the project, provided the cash flows

11-27 The direct cash flows are the easiest to predict. These would include the

investment in the new machine (less any salvage value of the old machine), the savings in

labor and other variable operating costs because of the decreased production time per

11-28 The first situation is reasonably clear. There is no legal or ethical reason not to

take the depreciation allowed by the tax law. The second is much more problematic.

Investing offshore is generally not illegal, although its ethics might be questionable. If

1. The present value is $640,000 and the annual payments are an annuity, requiring

use of Table 2:

2. (a)$640,000 = annual payment × 8.1109

annual payment = $640,000 ÷ 8.1109 = $78,906

3. (a) Total payments= 15 × $74,771 = $1,121,565

11-30 (10 min.) The initial step on solving present value problems focuses on a

1. Use Table 1, row 10, 4% column. Bank of America will lend $506,700,000.

2. Use Table 2, row 10, 4% column. Bank of America will lend $608,317,500.

The $75 million is a uniform periodic payment at the end of a series of years.

Therefore, it is an annuity. Its present value is:

461

PVA = $75,000,000 × 8.1109 = $608,317,500

In particular, note that Bank of America is willing to lend more than in

requirement 1 even though the interest rate is the same. Why? Because the bank

will receive the $750,000,000 more quickly if it receives 10 payments of

$75,000,000 per year rather than waiting to receive the entire $750,000,000 at

the end of 10 years.

11-31 (10-20 min.)

2. The annual rates would be halved and the periods doubled.

3. Present values rise because the money is repaid more quickly:

11-32 (10-15 min.)

1. $300,000 = Future amount × .6830

2. $300,000 = Annual installments × 3.1699

11-33 (10 min.)

The deferral cost Jenner $1,388,800 in present value, computed as follows:

Present value of $8,000,000 in 2 years $6,611,200

Present value of $8,000,000 today 8,000,000

462

2013 .9091 17,272,900 17,272,900

2014 .8264 17,354,400 23,965,600

Total $49,627,300 $48,238,500

Difference ($49,627,300 – $48,238,500) = $1, 388,800

11-34 (5-10 min.) This simple exercise requires use of both Table B-1 and Table B-2.

11-35 (20-25 min.) This basic exercise develops comfort with the tables and the NPV

method.

Number of years 7 18 18 28

b(5.2732 × CF) – $70,000 = ($10,009); CF = ($70,000 – $10,009)  5.2732 = $11,377

c(F × $30,000) – $50,000 = 231,157; F = $281,157  $30,000 = 9.3719

11-36 (10 min.)

Buy. The net present value is positive.

Initial outlay * $(44,000)

11-37 (10-15 min.)

2. 250,000 – 200,000 = 50,000 ├ an annuity of 3 payments (a)

3. 300,000 – 250,000 = 50,000 ┘

463

4. 450,000 – 300,000 = 150,000 ┐ an annuity of 2 payments

5. 500,000 – 350,000 = 150,000 ┘ deferred three years (b)

(a) $50,000 × 2.3216 $116,080

2. The NPV is positive because at a 12% rate, the present value of the net inflows

will be higher than at 14%, so NPV will increase.

1. NPV @ 10% = $2,300 × 6.8137 = $15,671.51 – $15,000 = $671.51. With a

required rate of 10%, the NPV is positive, so this investment is desirable.

3. The higher the required rate of return, the lower the NPV of future cash flows.

11-39 (10-15 min.)

1. NPV @ 10% = 10,000 × 3.7908 = $37,908 – $36,048 = $1,860

3. The NPV at the company’s cost of capital, 10%, is positive, so the project should

be accepted.

11-40 (30-45 min.)

1. $40,000 ÷ $10,000 = 4 years

3. a) NPV = ($10,000 × 2.3216) – $40,000 = ($16,784)

b) NPV = ($10,000 × 5.2161) – $40,000 = $12,161

5. NPV = ($9,000 × 2.9137) – $40,000 = ($13,777)

1. NPV = ($15,000 × 3.7908) – $52,000 = $56,862 – $52,000 = $4,862

3. (a) NPV = ($12,000 × 3.7908) – $52,000 = $45,490 – $52,000 = $(6,510)

(b) NPV = ($18,000 × 3.7908) – $52,000 = $68,234 – $52,000 = $16,234

5. (Savings × 3.7908) – $52,000 = 0

11-42 (5-10 min.) Amounts in thousands of dollars.

Annual Income Statement Effects:

(S) Sales 750

(E) Expenses excluding depreciation 275

(D) Depreciation 200

465

After-tax cash inflow from operations 304

Cash effect of depreciation tax deduction:

(D) Depreciation 200

Multiplied by tax rate ×.36

Tax savings due to depreciation 72

Total after-tax effect on cash 376

11-43 (5-10 min.)

Cash effect of operations:

Cash inflow from operations: $1,700,000 – $350,000 $1,350,000

Multiplied by (1 –37% tax rate) ×.63

11-44 (10 min.)

The month and day on which an asset is acquired does not affect its tax

1. 3-year property: 33.33% & 44.45% of $55,000 $18,332 $24,448

3. 5-year property: 20% and 32% of $16,000 3,200 5,120

11-45 (10 min.)

This problem could be solved by specifying appropriate schedules of tax savings

and computing the present values. However, the process would be extremely time-

466

(d) $950,000 × .7975 × .45 = $ 340,931

(e) $420,000 × .7782 × .25 = $ 81,711

11-46 (10-15 min.)

Annual addition to profit = 25% × $14,000 = $3,500.

1. Payback period is $28,000 ÷ $3,500 = 8 years. It is not a good measure of

2. NPV = $5,114. Reject the proposal because NPV is negative.

3. ARR = (Increase in average cash flow – Increase in depreciation) ÷ Initial

1. Investment A payback period: $36,000 ÷ $4,000 = 9 years

2. NPV of A: $4,000 × 9.8181 = $39,272 – $36,000 = $3,272

3. The payback model does not consider the overall profitability of the two investments.

It ignores all cash flows beyond the payback period and gives all cash inflows during the

11-48 (15 min.)

2. $7,000 × 6.1446 = $43,012. The company should buy because the net present

value is a positive $43,012 – $28,000 = $15,012.

11-49 (30 min.)

1 & 2. See Exhibit 11-49 on the following page for requirements 1 and 2.

The footnotes for the exhibit follow:

a Be sure to use a nominal discount rate, which includes an element attributable to

3. The method of Requirement 1 is correct. The required rate of return includes an

inflation element, and the cash inflows are adjusted for inflation. In Requirement

2 the required rate of return includes an inflation element, but the cash inflows

468

EXHIBIT 11–49 At 25 Percent Sketch of Relevant Cash Flows

(See footnotes on previous page.) P.V. Present (in dollars)

Factor Value ––––––––––––––––––––––––––––––––––––

0 1 2 3 4 5 6

1. Correct Analysis

Cash operating inflows:a

Pretax inflow in year-0 dollars $140,000

Tax effect at 35% 49,000

After-tax effect $ 91,000

2. Incorrect Analysis

Cash operating inflows