426
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CHAPTER 15
CAPITAL BUDGETING
QUESTIONS
1. A capital asset is a long-lived asset acquired by a firm. Capital assets provide the
2. Cash flows are the focus of capital budgeting investments just as cash flows are
of cash flows and, therefore, are not used in capital budgeting.
3. Time lines provide clear visual models of a project’s expected cash inflows and out-
4. The payback method measures the time expected for a firm to recover its investment
5. Return of capital means the investor is receiving the principal that was originally
6. A project’s NPV is the present value of all cash inflows less the present value of
tal.
7. It is highly unlikely that the estimated NPV will exactly equal the actual NPV
of working capital needed at the beginning of the project life.
8. The profitability index (PI) is calculated by dividing the discounted cash inflows
by the initial investment. The NPV method subtracts the initial investment from
equal to or greater than 1 is equivalent to a NPV equal to or greater than zero and
indicates that the investment will provide an acceptable return on capital.
Chapter 15 427
9. The IRR is the rate that would cause the NPV of a project to equal zero. A project
10. The amount of depreciation for a year is one factor that helps determine the
amount of cash outflow for income taxes. Therefore, although depreciation is not
11. The four questions are:
1. Is the activity worthy of an investment?
2. Which assets can be used for the activity?
Life of the asset
Amount of cash flows
13. In capital budgeting, sensitivity analysis is used to determine the limits of value
for input variables (e.g., discount rate, cash flows, asset life, etc.) beyond which
14. Postinvestment audits are performed to determine whether the realized return
matches the expected return on a project. Postinvestment audits are typically per-
15. The time value of money refers to the concept that money has time-based earnings
discounting process strips away the imputed rate of return in future values, thus
present values are less than future values.
16. ARR = Average annual profits ÷ Average investment
Unlike the rate used to discount cash flows or to compare to the cost of capital rate,
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EXERCISES
17. Investors are ultimately most interested in cash flows. Investors cannot spend ac-
amining only cash flows. Hence, accounting earnings are only useful to investors
18.
Cash flows
Period:
0
1
2
3
4
5
(Purchase)
Savings
–3,000,000
900,000
900,000
900,000
900,000
900,000
Accounting earnings
Period:
0
1
2
3
4
5
Expense savings
900,000
900,000
900,000
900,000
900,000
Depreciation
–600,000
–600,000
–600,000
–600,000
–600,000
Increase in
accounting earnings
300,000
300,000
300,000
300,000
300,000
19. No solution provided.
market interest rates. As market interest rates change, the value of securities change
21. a. Payback = $3,000,000 ÷ $600,000 per year = 5 years
b.
Year
Amount
Cumulative Amount
1
$300,000
$ 300,000
2
300,000
600,000
3
300,000
900,000
4
300,000
1,200,000
5
300,000
1,500,000
6
400,000
1,900,000
7
400,000
2,300,000
8
400,000
2,700,000
9
400,000
3,100,000
10
400,000
3,500,000
years.
Chapter 15 429
22. a. Investment = $140,000 + $180,000 = $320,000
Year
Amount
Cumulative Amount
1
$70,000
$ 70,000
2
78,000
148,000
3
72,000
220,000
4
56,000
276,000
5
50,000
326,000
6
48,000
374,000
7
44,000
418,000
posed product line.
b. Yes. Houston Fashions should also use a discounted cash flow technique so as
to consider both the time value of money and the cash flows that occur after the
payback period.
23.
Point in Time
Cash Flows
PV Factor
Present Value
0
$(1,800,000)
1.0000
$(1,800,000)
1
280,000
0.8929
250,012
2
280,000
0.7972
223,216
3
340,000
0.7118
242,012
4
340,000
0.6355
216,070
5
340,000
0.5674
192,916
6
288,800
0.5066
146,306
7
288,800
0.4524
130,653
8
288,800
0.4039
116,646
9
260,000
0.3606
93,756
10
260,000
0.3220
83,720
NPV
$ (104,693)
24. a. The contribution margin of each part is $1 (or $7.50 – $6.50)
Contribution margin per year = $1 100,000 = $100,000
Point in Time
Cash Flows
PV Factor
Present Value
0
$(500,000)
1.0000
$(500,000)
1–8
(20,000)
5.5348
(110,696)
1–8
100,000
5.5348
553,480
NPV
$ (57,216)
c. Other considerations would include whether refusing to produce this part for
the customer would cause a loss of other business from that customer. The
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26. a. PV of inflows: $91,000 6.4177 = $584,011
less than 1.00.
c. To be acceptable, a project must generate a PI of at least 1; a PI greater than 1
equates to an NPV > 0.
27. a. PV = Discount factor × Annual cash inflow
$700,000 = Discount factor $144,000
b. Yes. The IRR on this proposal is greater than the firm’s hurdle rate of 7 percent.
c. $700,000 = 5.9713 Annual cash flow
28. a. PV = Discount factor × Annual cash inflow
$1,800,000 = Discount factor $300,000
The project is acceptable because the IRR exceeds the discount rate.
particularly if the investment would cause layoffs.
29. Investment cost = $375,000 × Discount factor for 14%, 7 years
NPV = $375,000 × Discount factor (10%, 7 years) – $1,608,113
30. a. Annual depreciation = $1,000,000 ÷ 8 years = $125,000 per year
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b. Accelerated method
$1,000,000 0.30 0.40 0.9259
=
$111,108
$600,000 0.30 0.40 0.8573
=
61,726
$360,000 0.30 0.40 0.7938
=
34,292
$216,000 0.30 0.40 0.7350
=
19,051
$129,600* 0.30 0.6806
=
26,462
Total
$252,639
*In the final year, the remaining undepreciated cost is expensed.
c. The depreciation benefit computed in (b) exceeds that computed in (a) solely
31. a. SLD = $18,000,000 ÷ 8 years = $2,250,000 per year
Before-tax CF
$ 3,100,000
Less depreciation
(2,250,000)
Before-tax NI
$ 850,000
Less tax (30%)
(255,000)
NI
$ 595,000
Add depreciation
2,250,000
After-tax CF
$ 2,845,000
Point in Time
Cash Flows
PV Factor
Present Value
0
$(18,000,000)
1.0000
$(18,000,000)
1–8
2,845,000
6.4632
18,387,804
NPV
$ 387,804
The project is acceptable because the NPV is positive.
b.
Years 1 and 2
Years 3–8
Before-tax CF
$ 3,100,000
$ 3,100,000
Less depreciation
(4,140,000)
(1,620,000)
Before-tax NI
$(1,040,000)
$ 1,480,000
Tax (tax benefit)
(312,000)
444,000
After-tax NI
$ (728,000)
$ 1,036,000
Add depreciation
4,140,000
1,620,000
After-tax CF
$ 3,412,000
$ 2,656,000
Point in Time
Cash Flows
PV Factor
Present Value
0
$(18,000,000)
1.0000
$(18,000,000)
1–2
3,412,000
1.8594
6,344,273
3–8
2,656,000
4.6038
12,227,693
NPV
$ 571,966
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c. Before-tax CF
$ 3,100,000
Less depreciation
(2,250,000)
Before-tax NI
$ 850,000
Less tax (40%)
(340,000)
NI
$ 510,000
Add depreciation
2,250,000
After-tax CF
$ 2,760,000
Point in Time
Cash Flows
PV Factor
Present Value
0
$(18,000,000)
1.0000
$(18,000,000)
1–8
2,760,000
6.4632
17,838,432
NPV
$ (161,568)
Years 1 and 2
Years 3–8
Before-tax CF
$ 3,100,000
$3,100,000
Less depreciation
4,140,000
1,620,000
Before-tax NI
$(1,040,000)
$1,480,000
Tax (tax benefit)
(416,000)
592,000
After-tax NI
$ (624,000)
$ 888,000
Add depreciation
4,140,000
1,620,000
After-tax CF
$ 3,516,000
$2,508,000
Point in Time
Cash Flows
PV Factor
Present Value
0
$(18,000,000)
1.0000
$(18,000,000)
1–2
3,516,000
1.8594
6,537,650
3–8
2,508,000
4.6038
11,546,330
NPV
$ 83,980
The equipment investment is acceptable.
32. a. Tax: $99,000 – $18,000 = $81,000
b. CFAT = Current market value – Taxes
33. a. payback
b. NPV, PI
c. IRR
34. a. payback, NPV, PI, IRR
Chapter 15 433
e. payback, NPV, PI, IRR
35. a. Project Name
NPV
PI
IRR
Film studios
$3,578,910
1.18
13.03%
Cameras & equipment
1,067,920
1.33
18.62
Land improvement
2,250,628
1.45
19.69
Motion picture #1
1,040,276
1.06
12.26
Motion picture #2
1,026,008
1.09
14.09
Motion picture #3
3,197,320
1.40
21.32
Corporate aircraft
518,916
1.22
18.15
b. Ranking according to:
NPV
PI
IRR
1. Film studios
Land improvement
MP #3
2. MP #3
MP #3
Land improvement
3. Land improvement
Cameras & equip.
Cameras & equip.
4. Cameras & equip.
Corp. aircraft
Corp. aircraft
5. MP #1
Film studios
MP #2
6. MP #2
MP #2
Film studios
7. Corp. aircraft
MP #1
MP #1
c. Suggested purchases:
NPV
1. Motion picture #3 @ $8,000,000
$3,197,320
2. Land improvement @ $5,000,000
2,250,628
3. Cameras & equipment @ $3,200,000
1,067,920
4. Corporate aircraft @ $2,400,000
518,916
Total NPV
$7,034,784
36. a. Cash flow Annuity factor = $160,000
37. a. NPV = ($28,000 4.8684) – $100,000 = $36,315
b. Annuity factor $28,000 = $100,000
38. PV = FV × Discount factor
39. Cost = $8,000 + PV($800 annuity) = $8,000 + ($800 37.9740*) = $38,379.20
434 Chapter 15
40. a. PV = Future value Discount factor
b. PV = Future value Discount factor
c. PV = Future value Discount factor
d. Present value = Annuity × Annuity discount factor
e. Year 1 receipt:
$ 50,000 0.9346 =
$ 46,730
Year 2 receipt:
$ 55,000 0.8734 =
48,037
Year 3 receipt:
$ 60,000 0.8163 =
48,978
Year 4 receipt:
$100,000 0.7629 =
76,290
Year 5 receipt:
$100,000 0.7130 =
71,300
Year 6 receipt:
$100,000 0.6663 =
66,630
Year 7 receipt:
$100,000 0.6228 =
62,280
Year 8 receipt:
$100,000 0.5820 =
58,200
Year 9 receipt:
$ 70,000 0.5439 =
38,073
Year 10 receipt:
$ 45,000 0.5084 =
22,878
Present value
$539,396
criterion of 18 percent.
42. a. Annual cash receipts
$15,000
Cash expenses
(3,000)
Net cash flow before taxes
$12,000
Depreciation
(6,667)
Income before tax
$ 5,333
Taxes
(1,600)
Net income
$ 3,733
Depreciation
6,667
Annual after-tax cash flow
$10,400
Chapter 15 435
PROBLEMS
43. a. A lease is found appealing by consumers because it often results in a lower
ing.
b. No. A consumer should be provided with all necessary information to make a
fair comparison between the lease and purchase alternative.
the vehicle.
44. a. Although the 8 percent hurdle rate may be appropriate for most projects, it may
c. Hernandez should justify the investment based both on the potential future fi-
45. a. ($000s omitted)
t0
t1
t2
t3
t4
t5
t6
t7
t8
Investment
–(190)
New CM
60
60
60
60
60
60
60
60
Oper. costs
0
–20
–27
–27
–27
–30
–30
–30
–33
Cash flow
–(190)
40
33
33
33
30
30
30
27
b. Year
Cash Flow
Cumulative Cash Flow
1
$40,000
$ 40,000
2
33,000
73,000
3
33,000
106,000
4
33,000
139,000
5
30,000
169,000
6
30,000
199,000