Accounting Chapter 19 Homework The Outcome Covers The Cost Capital Exercise

19-1

CHAPTER 19

CAPITAL INVESTMENT

DISCUSSION QUESTIONS

1. Independent projects are such that the

acceptance of one does not preclude the ac-

ceptance of another. With mutually exclusive

projects, however, acceptance of one pre-

cludes the acceptance of others.

2. The timing and quantity of cash flows de-

termine the present value of a project. The

present value is critical for assessing wheth-

er or not a project is acceptable.

3. By ignoring the time value of money, good

projects can be rejected and bad projects

accepted.

4. The payback period is the time required to

recover the initial investment. It is used for

three reasons: (a) A measure of risk. Rough-

ly, projects with shorter paybacks are less

risky. (b) Obsolescence. If the risk of obso-

lescence is high, firms will want to recover

funds quickly. (c) Self-interest. Managers

want quick paybacks so that short-run per-

formance measures are affected positively,

enhancing chances for bonuses and promo-

tion.

5. The accounting rate of return is the average

income divided by investment.

6. The cost of capital is the cost of investment

funds and is usually viewed as the weighted

average of the costs of funds from all sources.

In capital budgeting, the cost of capital is the

rate used to discount future cash flows.

7. Disagree. Only if the funds received each

period from the investment are reinvested to

earn the IRR will the IRR be the actual rate

of return.

8. If NPV  0, then the investment is

acceptable. If NPV < 0, then the investment

should be rejected.

9. NPV signals which investment maximizes

firm value; IRR may provide misleading sig-

nals. IRR may be popular because it pro-

vides the correct signal most of the time,

and managers are accustomed to working

with rates of return.

10. NPV analysis is only as good as the accura-

cy of the cash flows. If cash flows are not

accurate, then incorrect investment deci-

sions can be made.

11. Gains and losses on the sale of existing

assets should be considered.

12. MACRS provides higher depreciation (a

non-cash expense) in earlier years than

straight-line does. Depreciation expense

provides a cash inflow from the tax savings

it produces. As a consequence, the present

value of the shielding benefit is greater for

MACRS.

13. Intangible and indirect benefits are important

factors—more important in the advanced

manufacturing and P2 environments. Great-

er quality, more reliability, reduced lead

times, improved delivery, and the ability to

maintain or increase market share are ex-

amples of intangible benefits. Reductions in

support labor in such areas as scheduling

and stores are indirect benefits.

14. A postaudit is a follow-up analysis of an

investment decision. It compares the pro-

jected costs and benefits with the actual

costs and benefits. It is especially valuable

for advanced technology investments since

it reveals intangible and indirect benefits that

can be considered in similar investments in

the future.

15. Sensitivity analysis involves changing

assumptions to see how the changes affect

the original outcome. In capital investment

decisions, sensitivity analysis can be used to

help assess the risk of a project. Uncertainty

in forecasted cash flows can be dealt with by

altering projections to see how sensitive the

decision is to errors in estimates.

CORNERSTONE EXERCISES

Cornerstone Exercise 19.1

1. Even cash flows:

Payback period = Original investment/Annual cash flow

2. Uneven cash flows:

Unrecovered Investment Annual Time Needed

Year (beginning of year) Cash Flow for Payback

1 ……………… $360,000 $112,500 1.0 year

2 ……………… 247,500 142,500 1.0 year

3. The payback for the laundry facility is 2.4 years ($360,000/150,000). The laun-

Cornerstone Exercise 19.2

1. Yearly depreciation expense: ($170,000 – $0)/5 = $34,000

Year 1 net income = $68,000 – $34,000 = $34,000

2. Total net income (five years) = $238,000

19-3

Cornerstone Exercise 19.2 (Concluded)

3. Average net income = $221,000/5 = $44,200. Thus, ARR = $44,200/$170,000 =

0.26, which is less than the ARR of the echocardiogram. The second project

Cornerstone Exercise 19–3

1. Year Item Cash Flow

0 Equipment $(800,000)

Working capital (100,000)

2. Year Cash Flow Discount Factor* Present Value

0 …………………………... $(900,000) 1.000 $(900,000)

1–4 …………………………. 300,000 3.312 993,600

3. Correcting for the overestimation error of $150,000 would cause the product

to be rejected.

Year Cash Flow Discount Factor** Present Value

0 …………………………... $(900,000) 1.000 $(900,000)

19-4

Cornerstone Exercise 19.4

1. df = $900,000/$300,000 = 3.000. Since the life of the investment is four years,

we must find the fourth row in Exhibit 19B-2 and move across this row until

2. To find the IRR, we must find i by trial and error such that $775,000 =

$400,000/(1 + i) + $500,000/(1 + i)2. Using i = 0.12 as the first guess, Exhibit

19B-1 yields discount factors of 0.893 and 0.797 and thus the following pre-

sent value for the two cash inflows:

P = (0.893 × $400,000) + (0.797 × $500,000)

= $755,700

3. df = $900,000/$250,000 = 3.600. Using Exhibit 19B-2, this discount factor now

Cornerstone Exercise 19.5

1. Clearlook System: NPV Analysis

Year Cash Flow Discount Factor* Present Value

0 …………………………... $(900,000) 1.000 $ (900,000)

19-5

Cornerstone Exercise 19.5 (Concluded)

2. Goodview System: NPV Analysis

Year Cash Flow Discount Factor* Present Value

0 …………………………... $(800,000) 1.000 $(800,000)

3. IRR Analysis:

Clearlook: Discount factor = Initial investment/Annual cash flow

Goodview: Discount factor = Initial investment/Annual cash flow

= 3.265**

*From Exhibit 19B-2, df = 3.273 implies that IRR ≈ 16 percent

**From Exhibit 19B-2, df = 3.265 implies that IRR is slightly greater than

16 percent.

Cornerstone Exercise 19.6

1. CF = NI + NC = $54,000 + $120,000 = $174,000

2. (1 – t) × Revenue = (1 – 0.40) × $360,000 = $216,000

3. Year (1 – t)Ra –(1 – t)Cb tNCc CF

1 ………………………………….. $216,000 $(90,000) $48,000 $174,000

2 ………………………………….. 216,000 (90,000) 48,000 174,000

19-6

EXERCISES

Exercise 19.7

1. Payback period = $93,750/$31,250 = 3.00 years

3. Payback period:

Cash Flow Unrecovered Investment

Year 1 …………………………….. $42,000 $294,000

Year 2 …………………………….. 58,800 235,200

Year 3 …………………………….. 84,000 151,200

Exercise 19.8

1. F = $5,000(1.03)2 = $5,304.50

2. 4%: P = $80,000 × 0.790 = $63,200

CF(4.623) = $500,000

19-7

Exercise 19.9

1. NPV = P – I

2. df = Investment/Annual cash flow

Exercise 19.10

1. Payback period = Original investment/Annual cash inflow

2. Yearly depreciation expense: ($2,293,200 – $0)/5 = $458,640

Accounting rate of return = Average income/Investment

3. Year Cash Flow Discount Factor Present Value

4. P = CF(df) = I for the IRR, thus,

df = Investment/Annual cash flow

19-8

Exercise 19.11

MRI equipment:

Year Cash Flow Discount Factor Present Value

0 …………… $(425,000) 1.000 $(425,000)

1 …………… 200,000 0.893 178,600

Biopsy equipment:

Year Cash Flow Discount Factor Present Value

0 …………… $(425,000) 1.000 $(425,000)

1 …………… 50,000 0.893 44,650

2 …………… 50,000 0.797 39,850

Exercise 19.12

1. MRI equipment:

Payback period = $200,000 1.00 year

100,000 1.00

Biopsy equipment:

Payback period = $50,000 1.00 year

50,000 1.00

100,000 1.00

19-9

Exercise 19.12 (Concluded)

2. MRI equipment:

Average cash flow = ($200,000 + $100,000 + $150,000 + $100,000 + $50,000)/5

= $120,000

Average depreciation = $425,000/5

Biopsy equipment:

Average cash flow = ($50,000 + $50,000 + $100,000 + $200,000 + $237,500)/5

= $127,500

Exercise 19.13

1. a. Return of the original investment ………………………………………. $600,000

2. Present value of profit:

3. Year Cash Flow Discount Factor Present Value

0 ……………………… $(600,000) 1.000 $(600,000)

19–10

Exercise 19.14

1. P = I

= df × CF

2.914* × CF = $120,000

2. For IRR: (Discount factors from Exhibit 19B-2)

I = df × CF

I = 2.402 × CF (1)

Substituting equation (1) into equation (2):

NPV = (2.577 × CF) – (2.402 × CF)

Substituting CF = $10,000 into equation (1):

3. For IRR:

I = df × CF

$60,096 = df × $12,000

19–11

Exercise 19.14 (Concluded)

4. X = Cash flow in Year 4

Investment = 3X

Year Cash Flow Discount Factor Present Value

0 ……………………… (3X) 1.000 $ (3X)

1 ……………………… 15,000 0.909 13,635

–3X + $13,635 + $16,520 + $22,530 + 0.683X= $6,075

–2.317X + $52,685 = $6,075

Exercise 19.15

1. Payback period = Investment/Annual cash flow

= $9,000,000/$1,500,000

2. NPV = P – I

= (5.650 × $1,500,000) – $9,000,000

19–12

Exercise 19.15 (Concluded)

3. Payback period = $9,000,000/$1,800,000 = 5.00 years

NPV:

Year Cash Flow Discount Factor Present Value

0 ………………………. $(9,000,000) 1.000 $ (9,000,000)

IRR: df = $9,000,000/$1,800,000 = 5.000

IRR (without salvage value) is now between 14 percent and 16 percent

(approximately 15.13 percent).

Exercise 19.16

1. NPV System I:

Year Cash Flow Discount Factor Present Value

0 ………………………. $(120,000) 1.000 $(120,000)

1 ………………………. — — —

NPV System II:

Year Cash Flow Discount Factor Present Value

0 ………………………. $(120,000) 1.000 $(120,000)

1–2 …………………….. 76,628 1.736 133,026

19–13

Exercise 19.16 (Concluded)

IRR System I:

I = df × CF

$120,000 = $162,708/(1 + i)2

(1 + i)2 = $162,708/$120,000

IRR System II:

df = I/CF

= $120,000/$76,628

2. Modified comparison:

Year System I System II

0 …………………………………………… $(120,000) $(120,000)

1 …………………………………………… — —

Exercise 19.17

Project I:

CF = NI + Noncash expenses

Project II:

CF = [–(1 – t) × (Cash expenses)] + (t × Noncash expenses)

19–14

Exercise 19.18

1. Year Depreciation tNC df Present Value

1 …………………… $3,000 $1,200 0.893 $1,072

2. Year Depreciation* tNC df Present Value

1 …………………… $5,999 $2,400 0.893 $2,143

3. MACRS increases the present value of tax shielding by increasing the

amount of depreciation in the earlier years.

19–15

CPA-TYPE EXERCISES

Exercises19.19

Exercise 19.20

Exercise 19.21

c. The weighted-average cost of capital is frequently used as the hurdle rate

Exercise 19.22

c. Net present value is computed as the difference between project inflows and

outflows, discounted to present value as follows.

Inflows:

Years 1 through 5: $420,000 x 3.79 = $1,591,800

Year 6: $100,000 x .56 = $ 56,000

Exercise 19.23

c. The formula for calculating the payback period is:

Net Initial Investment / Increase in annual net after-tax cash flow

The payback method computes the years needed to recoup an investment.

19–16

PROBLEMS

Problem 19.24

1. Year 0 …………………………………………………………………………….. $(630,000)

Year 1:

Operating costs (0.60 × $52,500) ………………………………… $ (31,500)

Savings (0.60 × $364,500) ………………………………………….. 218,700

Depreciation shield [0.40 × ($630,000/7) × 0.5] ……………. 18,000

Total ……………………………………………………………………. $ 205,200

Years 2–7:

2. Payback period:

$205,200 1.00 year

3. Year Cash Flow Discount Factor Present Value

0 ………………………. $(630,000) 1.000 $(630,000)

1 ………………………. 205,200 0.862 176,882

2–7 …………………….. 223,200 3.176 708,883

8 ………………………. 205,200 0.305 62,586