PROBLEM 16-53 (30 MINUTES)
1. Payback period =
inflow cash tax–after annual
investment initial
(a) Mall restaurant:
(b) Downtown restaurant:
2.
Accounting rate of return
=
investment initial
taxes)income
and ondepreciati (including
expenses lincrementa average
revenue
lincrementa
average
−
4. Neither the payback period nor the accounting-rate-of-return method considers the
Chapter 16 – Capital Expenditure Decisions
PROBLEM 16-54 (35 MINUTES)
1. Payback period = 3 years*
2. Accounting rate of return (ARR) using initial investment:
3. Accounting rate of return (ARR) using average investment:
Chapter 16 – Capital Expenditure Decisions
PROBLEM 16-55 (50 MINUTES)
1. Schedule of cash flows in nominal dollars:
(1)
Year
(2)
After-Tax
Incremental
Cash Flow in
Real Dollars
(not including
depreciation shield)
(3)
Price
Index
(4)
After-Tax
Incremental
Cash Flow in
Nominal Dollars
(not including
depreciation shield)**
(5)
MACRS
Depreciation
(6)
Cash Flow:
Tax Savings
(depreciation .40)
(7)
Total
After-Tax
Cash Flow in
Nominal
Dollars
[Col. (4) +
Col.(6)]
20×0
$(188,000
)*
1.0000
$(188,000
)
—
—
$(188,000)
20×1
42,000
†
(1.20)1
=
1.2000
50,400
$200,000 20.00% = $40,000
$16,000
66,400
20×2
42,000
(1.20)2
=
1.4400
60,480
200,000 32.00% = 64,000
25,600
86,080
20×3
42,000
(1.20)3
=
1.7280
72,576
15,360
87,936
20×4
42,000
=
2.0736
87,091
200,000 11.52% = 23,040
96,307
20×5
42,000
(1.20)5
=
2.4883
20×6
42,000
(1.20)6
=
2.9860
*Acquisition cost of new satellite dish ………………..
)
Salvage value of old equipment …………………………
20,000
Incremental tax on gain on sale:
)
Chapter 16 – Capital Expenditure Decisions
2.
Nominal interest rate:
Real interest rate ………………………………………………………………………………….
.10
Inflation rate ………………………………………………………………………………………..
.20
Nominal interest rate ……………………………………………………………………………
.32
3. Net present value analysis:
Year
After-Tax
Cash Flow in
Nominal Dollars
Discount
Factor*
Present
Value
20×0
$(188,000)
1.000
$(188,000)
20×1
.758
20×2
.574
20×3
.435
20×4
.329
20×5
.250
20×6
.189
20×7
.143
PROBLEM 16-56 (50 MINUTES)
PROBLEM 16-56 (CONTINUED)
(1)
Year
(2)
After-Tax
Incremental
Cash Flow in
Real Dollars
(not including
depreciation shield)
(3)
MACRS
Depreciation
(4)
Cash Flow:
Tax Savings
[Depreciation .40]
(5)
Price
Index
(6)
Depreciation
Tax Shield in
Real Dollars
[Col. (4) ÷ Col. (5)]
(7)
Total
After-Tax
Cash Flow in
Real
Dollars
[Col. (2) + Col.(6)]
20×0
$(188,000
)*
—
—
1.0000
—
$(188,000)
20×1
42,000
†
$200,000 20.00% = $40,000
$16,000
(1.20)1
=
1.2000
$13,333
55,333
20×3
42,000
(1.20)3
=
1.7280
50,889
46,444
20×5
42,000
(1.20)5
=
2.4883
45,704
20×6
42,000
(1.20)6
=
2.9860
43,543
*Acquisition cost of new satellite dish ………………..
$(200,000
)
Salvage value of old equipment …………………………
20,000
Incremental tax on gain on sale:
)
$(188,000
)
Chapter 16 – Capital Expenditure Decisions
PROBLEM 16-56 (CONTINUED)
3. Net present-value analysis:
Year
After-Tax
Cash Flow in
Real Dollars
Discount
Factor*
Present
Value
20×0
$(188,000)
1.000
$(188,000)
20×1
55,333
.909
50,298
20×2
.826
20×3
.751
20×4
.683
20×5
.621
20×6
.564
20×7
.513
Chapter 16 – Capital Expenditure Decisions
SOLUTIONS TO CASES
CASE 16-57 (60 MINUTES)
1. The two main alternatives for the Board of Education are as follows:
2. If the board decides to use minibuses, then there are two options for the full-size
buses:
3. Net-present-value analysis of options for full-size buses:
(a) Sell five full-size buses:
CASE 16-57 (CONTINUED)
4. Net present-value analysis of minibus purchase decision.
In the following incremental cost analysis, parentheses denote cash flows favoring
the full-size bus alternative.
Incremental annual cost of compensation for bus
drivers if minibuses are used
CASE 16-57 (CONTINUED)
5. Internal rate of return on the minibuses:
(a) First, calculate the annual cost savings if the minibuses are used.
Remember that the full-size buses will be kept in reserve.
Annual savings on bus charter fees ($30,000 – $5,000) …………………………..
$25,000
Annual incremental cost of compensation for bus
(54,000
)
Total annual cost savings if minibuses are used …………………………..
$61,000
(b) Second, calculate the initial cost if the minibuses are purchased:
Cost of redesigning bus routes, retraining drivers, etc. …………………………..
)
)
Initial cost ……………………………………………………………………………………
)
Annual incremental maintenance and operating costs
(c) Third, find the internal rate of return:
Annuity discount factor associated
with the internal rate of return
=
savings cost annual
cost initial
6. The cost of purchasing a full-size bus ($90,000) is irrelevant, because the board is
7. Peter Reynolds, the vice president for sales at the automobile dealership, is acting
improperly. First, he should not try to pressure his friend into recommending that the
CASE 16-57 (CONTINUED)
Chapter 16 – Capital Expenditure Decisions
CASE 16-58 (60 MINUTES)
1. The net present value of the proposed investment is $(235,280), calculated as follows:
INSTANT DINNERS, INC.
NET-PRESENT-VALUE ANALYSIS
Time 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
New equipment …………………………..
$(4,500,000
)
Working capital …………………………..
(1,000,000
)
$1,000,000
Disposition of
equipment:
Operating revenue
$700,000
$700,000
Operating savingsa
)
Tax effect b…………………………..
)
)
)
)
(15,000
)
)
)
)
$(5,240,000
)
$1,005,000
$1,005,000
$2,065,000
Present value …………………………..
$(5,240,000
)
Net present value …………………………..
)
Chapter 16 – Capital Expenditure Decisions
CASE 16-58 (CONTINUED)
a
Operating savings for Years 1, 2, 3, 4, 6, 7, 8:
Manufacturing cost reduction ………………………………………………………….
$ 500,000
Maintenance cost reduction …………………………………………………………….
300,000
Less: Increased operating costs ……………………………………………………..
)
$ 600,000
Year 5:
Same as above ……………………………………………………………………………….
$ 600,000
Less: Equipment repairs …………………………………………………………………
)
)
b
Tax effects:
At time 0; disposal of forklifts:
Book value ……………………………………………………………………………………..
$ 500,000
Less: Salvage value …………………………………………………………………………
(100,000
)
Tax loss …………………………………………………………………………………………
$ 400,000
$ 160,000
Years 1 through 4:
Revenue ………………………………………………………………………………………….
$ 700,000
Operating-cost savings ……………………………………………………………………
600,000
Loss of depreciation on forklifts ……………………………………………………..
100,000
*
Depreciation on new equipment ………………………………………………………
Increase in taxable income ………………………………………………………………
)
CASE 16-58 (CONTINUED)
Year 5:
Revenue ………………………………………………………………………………………….
$ 700,000
Operating-costs* ……………………………………………………………………………..
(200,000
)
Loss of depreciation on forklifts ……………………………………………………..
100,000
Depreciation on new equipment ………………………………………………………
)
Increase in taxable income ………………………………………………………………
)
Years 6 and 7:
Revenue ………………………………………………………………………………………….
$ 700,000
Operating-cost savings ……………………………………………………………………
600,000
Depreciation on new equipment ………………………………………………………
)
Increase in taxable income ………………………………………………………………
$ 737,500
)
Year 8:
Revenue ………………………………………………………………………………………….
$ 700,000
Operating-cost savings ……………………………………………………………………
600,000
Depreciation on new equipment ………………………………………………………
(562,500
)
Salvage value of new equipment ……………………………………………………..
Increase in taxable income ………………………………………………………………
$ 837,500
)
2. Referring to the specific ethical standards of competence, confidentiality, integrity,
and credibility, Leland Forrest should evaluate Bill Rolland’s directives as follows:
Competence. Forrest has a responsibility to present complete and clear reports
Chapter 16 – Capital Expenditure Decisions
CASE 16-58 (CONTINUED)
Integrity. Rolland is engaging in activities that could prejudice him from carrying
out his duties ethically. In evaluating Rolland’s directive as it affects Forrest, Forrest
3. Leland Forrest should take the following steps to resolve this situation:
• Forrest should first investigate to see if Instant Dinners, Inc. (IDI) has an
established policy for resolution of ethical conflicts and follow those procedures.
• If this policy does not resolve the ethical conflict, the next step is for Forrest to
discuss the situation with his supervisor, Rolland, and see if he can obtain
Chapter 16 – Capital Expenditure Decisions
FOCUS ON ETHICS (See page 710 in the text.)
2. Marie Fenwar should approve Research Proposal I. It has a higher NPV than
Research Proposal II. Moreover, the NPV of Proposal I is positive, while the NPV of
Proposal II is negative.
Time 0
Year 1
Year 2
Year 3
Year 4
Year 5
Research Proposal I:
Equipment
acquisition ……………………….
$(40,000
)
Contract fee ……………………….
$100,000
$100,000
$100,000
$100,000
$100,000
Operating costs ………………….
(150,000
)
(120,000
)
(75,000
)
(40,000
)
(40,000
)
Total cash flow ……………………
$ (40,000
)
$ (50,000
)
$ (20,000
)
Present value …………………………
$ (40,000
)
$ (46,300
)
$ (17,140
)
Research Proposal II:
Equipment
acquisition ……………………….
$(70,000
)
Contract fee ……………………….
$100,000
$100,000
$100,000
$100,000
$100,000
Operating costs ………………….
(75,000
)
(75,000
)
(95,000
)
(95,000
)
(95,000
)
Total cash flow ……………………
$ (70,000
)
Present value …………………………
$ (70,000
)
3. Marie Fenwar acted unethically in approving Research Proposal II. Proposal I has a
positive NPV, and it is higher than the NPV for Proposal II, which is negative. Fenwar