Chapter 12
The Capital Budgeting Decision
Discussion Questions
12-1. What are the important administrative considerations in the capital budgeting
process?
12-2. Why does capital budgeting rely on analysis of cash flows rather than on net
income?
Cash flow rather than net income is used in capital budgeting analysis because
12-3. What are the weaknesses of the payback method?
12-4. What is normally used as the discount rate in the net present value method?
12-5. What does the term mutually exclusive investments mean?
The selection of one investment precludes the selection of other alternative
investments because the investments compete with one another. For example, if
12-6. How does the modified internal rate of return include concepts from both the
traditional internal rate of return and the net present value methods?
The modified internal rate of return calls for the determination of the interest
12-7. If a corporation has projects that will earn more than the cost of capital, should
it ration capital?
From a purely economic viewpoint, a firm should not ration capital. The firm
12-8. What is the net present value profile? What three points should be determined
to graph the profile?
The net present value profile allows for the graphic portrayal of the net present
value of a project at different discount rates. Net present values are shown along
the vertical axis and discount rates are shown along the horizontal axis.
12-9. How does an asset’s ADR (asset depreciation range) relate to its MACRS
category?
The ADR represents the asset depreciation range or the expected physical life of
Chapter 12
Problems
1. Cash flow (LO12-2) Assume a corporation has earnings before depreciation and taxes of
$90,000, depreciation of $40,000, and a 30 percent tax bracket. Compute its cash flow using the
following format:
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
12-1. Solution:
Earnings before depreciation and taxes $90,000
Depreciation –40,000
Earnings before taxes 50,000
2. Cash flow (LO12-2) Assume a corporation has earnings before depreciation and
taxes of $100,000, depreciation of $40,000, and that it has a 40 percent tax bracket.
a. Compute its cash flow using the following format:
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 40% _____
Earnings after taxes _____
Depreciation _____
b. Compute the cash flow for the company if depreciation is only $20,000.
c How much cash flow is lost due to the reduced depreciation from $40,000 to
$20,000?
12-2. Solution:
a. Earnings before depreciation and taxes $100,000
Depreciation – 40,000
Earnings before taxes 60,000
b. Earnings before depreciation and taxes $100,000
Depreciation – 20,000
Earnings before taxes 80,000
c. Cash flow ($40,000) $ 76,000
3. Cash flow (LO12-2) Assume a firm has earnings before depreciation and taxes of $200,000
and no depreciation. It is in a 40 percent tax bracket.
a. Compute its cash flow.
b. Assume it has $200,000 in depreciation. Recompute its cash flow.
c. How large a cash flow benefit did the depreciation provide?
12-3. Solution:
a.
Earnings before depreciation and taxes $200,000
b.
Earnings before depreciation and taxes $200,000
Depreciation –200,000
c.
The $200,000 in depreciation provided a cash flow benefit
of $80,000.
4. Cash flow (LO12-2) Assume a firm has earnings before depreciation and taxes of
$440,000 and depreciation of $140,000.
a. If it is in a 35 percent tax bracket, compute its cash flow.
b. If it is in a 20 percent tax bracket, compute its cash flow.
12-4. Solution:
a. Earnings before depreciation and taxes $440,000
Depreciation 140,000
Earnings before taxes 300,000
b. Earnings before depreciation + taxes $440,000
Depreciation 140,000
Earnings before taxes 300,000
5. Cash flow versus earnings (LO12-2) Al Quick, the president of a New York Stock
Exchange —listed firm, is very short-term oriented and interested in the immediate
consequences of his decisions. Assume a project that will provide an increase of $2 million
in cash flow because of favorable tax consequences, but carries a two-cent decline in
earnings per share because of a write-off against first-quarter earnings. What decision
might Mr. Quick make?
12-5. Solution:
Al Quick
Being short-term oriented, he may make the mistake of
turning down the project even though it will increase cash flow
6. Payback method (LO12-3) Assume a $250,000 investment and the following cash flows
for two products:
Year Product X Product Y
1 $90,000 $50,000
2 90,000 80,000
3 60,000 60,000
4 20,000 70,000
Which alternatives would you select under the payback method?
12-6. Solution:
Payback for Product X Payback for Product Y
$250,000 – 90,000 1 year $250,000 – 50,000 1 year
160,000 – 90,000 2 years 200,000 – 80,000 2 years
7. Payback method (LO12-3) Assume a $40,000 investment and the following cash flows for
two alternatives.
Year
Investment X
Investment Y
1 $ 6,000 $15,000
2 8,000 20,000
3 9,000 10,000
4 17,000 —
5
20,000 —
Which of the alternatives would you select under the payback method?
12-7. Solution:
Payback for Investment X Payback for Investment Y
$40,000–$6,000 1 year $40,000–$15,000 1 year
34,000–8,000 2 years 25,000–20,000 2 years
8. Payback method (LO12-3) Assume a $90,000 investment and the following cash flows
for two alternatives.
Year Investment A Investment B
1…………….. $25,000 $40,000
2…………….. 30,000 40,000
3…………….. 25,000 28,000
4…………….. 19,000 —
5…………….. 25,000 —
a. Calculate the payback for investment A and B.
b. If the inflow in the fifth year for Investment A was $25,000,000 instead of $25,000,
would your answer change under the payback method?
12-8. Solution:
a. Payback for Investment A Payback for Investment B
$90,000 – $25,000 1 year $90,000 – $40,000 1 year
65,000 – 30,000 2 years 50,000 – 40,000 2 years
b. The $25,000,000 inflow would still leave the payback period for
9. Payback method (LO12-3) The Short-Line Railroad is considering a $140,000 investment
in either of two companies. The cash flows are as follows:
Year Electric Co.Water Works
1………………. $85,000 $30,000
2………………. 25,000 25,000
3………………. 30,000 85,000
4–10…………. 10,000 10,000
a. Using the payback method, what will the decision be?
b. Explain why the answer in part a can be misleading.
12-9. Solution:
Short-Line Railroad
a.
Payback for Electric Co. Payback for Water Works
$140,000 – $85,000 1 year $140,000 – $30,000 1 year
55,000 – 25,000 2 years 110,000 – 25,000 2 years
b. The answer in part a is misleading because the two
investments seem to be equal with the same payback period
10. Payback and net present value (LO12-3 and 4) X-treme Vitamin Company is
considering two investments, both of which cost $10,000. The cash flows are as follows:
Year Project A Project B
1……………….. $12,000 $10,000
2……………….. 8,000 6,000
3……………….. 6,000 16,000
a. Which of the two projects should be chosen based on the payback method?
b. Which of the two projects should be chosen based on the net present value method?
Assume a cost of capital of 10 percent.
c. Should a firm normally have more confidence in answer a or answer b.