CHAPTER 26
CAPITAL BUDGETING
Brief Learning
Exercises Topic Objectives Skills
B. Ex. 26.1 Understanding payback period 26-3 Analysis
B. Ex. 26.2 Use of return on investment 26-3 Analysis
B. Ex. 26.3 Comparing NPV and required rate of return 26-3, 26-4 Analysis
B. Ex. 26.4 Net present value computations 26-3 Analysis
B. Ex. 26.5 Computations for payback period 26-3 Analysis
B. Ex. 26.6 Capital investment challenges 26-1, 26-2 Analysis, judgment
B. Ex. 26.7 Net present value and required rate of return 26-3, 26-4 Analysis, judgment
B. Ex. 26.8 Capital budgeting behaviors 26-5 Analysis, judgment
B. Ex. 26.9 Net present value analysis 26-3 Analysis
B. Ex. 26.10 Nonfinancial investment concerns 26-2
Analysis, communication,
judgment
Learning
Exercises Topic Objectives Skills
26.1 Accounting terminology 26-1–26-5 Analysis
26.2 Payback period 26-1–26-3
Analysis, communication,
judgment
26.3 Understanding return on average investment 26-1, 26-3 Analysis
26.4 Discounting cash flows 26-3 Analysis
26.5 Understanding net present value relationships 26-3 Analysis
26.6 Analyzing a capital investment proposal 26-1, 26-3 Analysis
26.7 Analyzing capital investment proposal 26-1–26-4
Analysis, communication,
judgment
26.8 Analyzing capital investment proposal 26-1, 26-3 Analysis
26.9 Competing investment proposals
26-1, 26-2,
26-5
Analysis, communication,
judgment
26.10 Replacing existing equipment
26-1–26-3,
26-5
Analysis, communication,
judgment
26.11 Gains and losses on sale of equipment 26-3 Analysis
26.12 Depreciation effects on cash flows 26-3 Analysis
OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL
THINKING CASES
Learning
Exercises Topic Objectives Skills
26.13 Net present value in a not-for-profit 26-2, 26-3
Analysis, communication,
judgment
26.14 NPV of uneven cash flows 26-3 Analysis
26.15
Real World: Home Depot’s present value of
store closing costs
26-1–26–3
Analysis, communication,
judgment , research
Problems Learning
Sets A, B
Topic Objectives Skills
26.1 A,B
Capital budgeting and determination of
annual net cash flow
26-1–26–4 Analysis
26.2 A,B Analyzing capital investment proposals 26-1–26–4
Analysis, communication,
judgment
26.3 A,B Analyzing capital investment proposals 26-1–26–4
Analysis, communication,
judgment
26.4 A,B Capital budgeting using multiple models 26-1–26–4
Analysis, communication,
judgment
26.5 A,B Capital budgeting using multiple models 26-1–26–4
Analysis, communication,
judgment
26.6 A,B Analyzing a capital investment proposal 26-3 Analysis
26.7 A,B
Considering financial and nonfinancial
factors
26-1–26-4
Analysis, communication,
judgment
26.8 A,B
Analyzing competing capital investment
proposals
26-1–26-4
Analysis, communication,
judgment
26.9 A,B
Analyzing competing capital investment
proposals
26-1–26-5
Analysis, communication,
judgment
Critical Thinking Cases
26.1 How much is that laser in the window? 26-2–26-4
Analysis, communication,
judgment
26.2 Dollars and cents versus a sense of ethics 26-1–26-5
Analysis, communication,
research
26.3 International investments in outsourcing
Analysis, communication,
judgment
26.4 Real World: Red Robin Gourmet 26-5 Analysis, communication
Burgers judgment
(Ethics, fraud and corporate governance)
DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES
Problems (Sets A and B)
26.1 A,B
Toying with Nature/Monster Toys 30 Strong
Covers incremental analysis and three basic capital budgeting
techniques in a single problem.
26.2 A,B
Hibbing Technology/Virginia Technology 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.3 A,B
Welsh Industries/Jason Equipment Co. 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.4 A,B
Marengo/Samba 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.5 A,B
V.S. Yogurt/I.C. Cream 25 Medium
Basic capital budgeting. Compute the payback period, return on average
investment, and net present value of two investment alternatives.
Student must decide which investment to select.
26.6 A,B
Pathways Appliance Company/Cafield Appliance Company 30 Strong
Prepare a schedule showing the estimated incremental net income from
proposed introduction of a new product. Compute annual cash flow,
payback period, return on average investment, and net present value of
the investment proposal.
26.7 A,B
Doctors 40 Strong
Students must determine whether it is profitable for several doctors to
invest their money in an expensive piece of testing equipment. Requires
financial analysis and consideration of nonfinancial aspects of their
decision.
Below are brief descriptions of each problem and case. These descriptions are accompanied by the
estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume
use of the partially filled-in working papers.
26.8 A,B
Jefferson Mountain/Jackson Mountain 50 Strong
A small ski resort must decide between alternative investment
proposals. Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
26.9 A,B Sonic, Inc./Boom, Inc. 45 Strong
A software company is trying to decide how to market their software.
Students are asked to analyze financial and nonfinancial
considerations relevant to the decision.
Critical Thinking Cases
26.1
The Case of the Costly Laser
Compute the net present value of a proposal to replace existing
equipment with new, more efficient equipment. The sale of the
existing equipment will involve a large loss. Students are asked to
comment on the relevance of this sunk cost.
26.2
Grizzly Community Hospital 60 Strong
A small community hospital considers a major capital investment in
a regional kidney center. Students are asked to analyze financial and
nonfinancial information relevant to the decision, explore
alternative uses of resources, and help the hospital define its role.
26.3 International Investments in Outsourcing 20 Medium
The cash flows associated with offshore investments are identified.
Ethical considerations of asking domestic employees to train their
international replacements are considered.
26.4 Red Robin Gourmet Burgers 30 Medium
Ethics, Fraud & Corporate Governance
Governance violations at Red Robin Gourmet Burgers leads to
capital budgeting conflicts of interest.
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1.
2.
3.
4.
5.
6.
7.
8.
Capital budgeting is the process of planning and evaluating investments in plant assets. Capital
Corporate management would allow a lower rate of return for newly developing divisions, when
The major shortcoming in using the payback period as the sole criterion in capital budgeting
Timing differences are very important in present value computations and projects that have more
significant cash inflows after several years will inevitably have lower present values than projects
The present value of a future amount is the amount of money which, if invested today to earn a
Factors to consider in establishing a minimum required return on an investment proposal may
Discounting cash flows takes into consideration the timing of the earnings stream. The return on
Nonfinancial considerations associated with the installation of a fire sprinkler system may include
9.
10.
13.
14.
15.
If a company is replacing an asset, the first income tax consequence to be considered is
t
If an investment with no salvage value has a payback period that exceeds its estimated life, the
An investment’s contribution to income is not the same as its incremental cash flow because
One way to ensure that employee estimates of the costs and benefits of capital investments are
not overly optimistic or pessimistic is to implement a system for auditing capital budget
decisions. With an audit system in place, employees will be aware that their estimates will be
checked against actual results, and any biases discovered. Another step firms can take is to
Some capital investment proposals which may favor nonfinancial factors include a pollution
B. Ex. 26.1 The payback period is computed as follows:
B. Ex. 26.2 Proposal 1:
Proposal 2:
B. Ex. 26.3
B. Ex. 26.4 134,080$
B. Ex. 26.6
SOLUTIONS TO BRIEF EXERCISES
The estimated cash flows of replacement equipment often is relatively easy to estimate
because the company has experience with similar of assets. Thus, replacing a fleet of
If the investment proposal has a positive net present value of $20 when an 8% discount
Present value of expected annual cash flows ($40,000 × 3.352)
B. Ex. 26.6
(continued)
B. Ex. 26.7
B. Ex. 26.8
B. Ex. 26.9
Present value of expected annual cash savings ( X × 4.623) …………………….
= X
B. Ex. 26.10
If the initial outlay for the project is $125,000 and the net present value of the
future cash flows is $120,000, then the present value (based on the 12% required
The net present value cash flows could be optimistic because the outside sales
Sam’s should also consider the potential cannibalization of in-store sales, the
Alternatively, new technology is inherently difficult to estimate. For example, when
VCRs, DVD players, or I-Pods were first introduced to the market, the prices were
set fairly high because manufacturers could not estimate demand. As demand grew
Present value of proceeds from disposal ($100,000 × .630) ……………………
Total Present Value of investment’s future cash flows……………………
Cost of investment …………………………………………………………
SOLUTIONS TO EXERCISES
Ex. 26.1 a.
Ex. 26.2 a.
b.
c.
Incremental analysis
Based strictly on payback periods, the Akron Industries machine is more
attractive because its cost will be recovered one year sooner than the cost of the
If the Akron Industries machine has a payback period of 60 months (or 5 years),
its cost can be computed as follows:
Cost = $5,000 x 5 years = $25,000
A 6-year payback period for the Toledo Tools machine is computed as follows:
Sunk cost
Capital budgeting
Return on average investment
Salvage value
Payback period
cost in determining its net present value.)
Present value
Discount rate
Ex. 26.3
Thus, the average estimated net income of Investment B is:
Average Estimated Net Income =18% x $45,000 = $8,100
The average investment of Investment C is:
The missing data for each investment proposal are solved for as follows:
Investment A
Thus, the return on average investment of Investment A is:
Investment B
Investment C
Average Investment = $6,000 ÷ 25% = $24,000
Thus, the estimated salvage value of Investment C is:
d.
Ex. 26.5
Present value of annual net cash flows discounted at 10% for 10 years
Present value of annual net cash flows discounted at 12% for 10 years
Thus, the original investment cost of Investment D is:
Investment Cost = ($40,000 × 2) – $2,000 = $78,000
Average Investment = $8,000 ÷ 20% = $40,000
Investment A
($20,000 × 3.352) + ($10,000 × 2.283) = $67,040 + $22,830 = $89,870
There are several ways to approach this problem. Shown below is the present value
of $20,000 received annually for 5 years plus the present value of the additional
Investment B
The missing information for each investment is solved for as follows:
Ex. 26.3
(continued)
Investment D
The average investment of Investment D is:
Ex. 26.4 a.
$40,000 × .061 = $2,440
($16,000 × 3.352) + ($20,000 × .497) = $53,632 + $9,940 = $63,572
b.
$500,000 ÷ 2
c.
Return on average investment:
Net present value of proposal, discounted 5 years at an annual rate of 10%:
Total present value of annual net cash flows
Average Investment
Given a net present value of zero, we can conclude that the discounted present value of the
future cash flows associated with Investment B must equal the investment’s original cost of
$141,250.
Investment C
Thus, the annual cash outflows associated with the investment can be computed as follows:
($37,000 – Cash Outflows) × 5.650 = $141,250
($37,000 × 5.650) – (5.650 × Cash Outflows) = $141,250
$209,050 – (5.650 × Cash Outflows) = $141,250
Cash Outflows = $67,800 ÷ 5.650 = $12,000
$209,050 – $141,250 = (5.650 × Cash Outflows)
$67,800 = (5.650 × Cash Outflows)
($19,000 – $7,000) × PV Factor = $80,520
$12,000 × PV Factor = $80,520
PV Factor = $80,520 ÷ $12,000 = 6.71
Thus, the discount rate associated with the investment that yields a net present value of zero
can be computed as follows:
Present value of annual net cash flows discounted at ?% for 10 years
Ex. 26.7 a.
b.
c.
Ex. 26.9 a.
This is a very complex question with no single correct answer. If all division
managers commonly overstate cash flow projections in order to obtain funding
There are several nonfinancial issues that Northwest Records should consider.
First, musical tastes often change very quickly. As such, an estimate that the
Present value of net cash flows of $250,000 per year for 4
The payback period of the Seattle Sound investment is computed as follows:
The net present value of the Seattle Sound investment is computed as follows:
Ex. 26.9
b.
Ex. 26.10
a. Net present value:
Calculate depreciation expense under each alternative:
New machine ($120,000 ÷ 5 years) 24,000$
Old machine ($100,000 ÷ 5 years) 20,000
Increase in depreciation of new machine 4,000$
Calculate the incremental increase in annual income taxes resulting
from the purchase of the new machine:
Cost savings of new machine 34,000$
Calculate the incremental increase in annual cash flow resulting from
the purchase of the new machine:
Cost savings of new machine 34,000$
Less: Increase in income taxes (see above) 12,000
Increase in annual cash flow 22,000$
Calculate the tax savings resulting from the loss on the sale of the
old machine:
Book value of old machine 100,000$
Proceeds from sale 20,000
Loss on sale of disposal 80,000$
Income tax rate 40%
Tax savings resulting from loss on disposal 32,000$
The net present value of the new machine can now be computed as follows:
Present value of incremental annual cash flows discounted at 12%
for five years is $22,000 × 3.605 (from Exhibit 26.4) 79,310$
Present value of tax savings from loss on disposal of the old machine
discounted at 12% for 1 year is $32,000 × .893 (from Exhibit 26.3) 28,576
Present value of proceeds from sale of old equipment 20,000
Total present value 127,886$
Less: Cost of new machine 120,000
Net present value 7,886$
(Continued on the following page)
There are numerous controls that might be implemented to discourage the
overstatement of capital budgeting estimates. First, whenever possible, assumptions and
Less: Increase in depreciation (see above) 4,000
Increase in pretax income 30,000$
Income tax rate 40%
Increase in income taxes 12,000$
Ex. 26.10 b.
c.
Ex. 26.11
a. b.
$ 80,000 $ 20,000
Ex. 26.12
$ 150,000
c.
Perhaps the most important nonfinancial consideration for EnterTech to
consider is the future demand for portable CD players. If demand for the
product is less than five years, the investment in the new machine is far less
Because the decision of whether or not to invest in the new machine is highly
dependent on the cost savings estimate, EnterTech may want to obtain a second
Cash proceeds of sale
The hospital should consider how many MRIs currently used by competing
hospitals in the surrounding area, a consideration that could influence the
Sales
$ 18,000 $ (42,000)
$ 72,800
Tax Savings at 40%
Net cash effect of sale:
($80,000 – $7,200)
Taxes Paid at 40%
Gain (Loss) on Sale
Ex. 26.14
5% rate 5% NPV 8% rate 8% NPV
Year 1 0.952 $142,800 0.926 $138,900
Ex. 26.15
Note to instructor: To generate class discussion, have students identify any nonfinancial
factors that pertain to store closings. For instance, a primary nonfinancial factor is how
Home Depot bases its store closing decisions by comparing the related
undiscounted cash flows with carrying values of the stores targeted for closure.
Amount
$150,000
Year 2 0.907 199,540 0.857 188,540
Year 3 0.864 216,000 0.794 198,500
$220,000
$250,000
SOLUTIONS TO PROBLEMS SET A
30 Minutes, Strong PROBLEM 26.1A
TOYING WITH NATURE
a.
Estimated sales (80,000 units @ $6) 480,000$
Less estimated incremental costs:
Variable manufacturing costs (80,000 units @ $2.50) 200,000$
Fixed manufacturing costs (except depreciation) 45,000
b. Computation of annual net cash flow:
Cash receipts 480,000$
Less cash outlays:
Variable manufacturing costs 200,000$
Fixed costs (other than depreciation) 45,000
Selling and general expenses 55,000
Income taxes expense 28,000 328,000
Annual net cash flow from sale of new product 152,000$
c. (1)
(3) Net present value of project, discounted at 15%:
Total present value of annual net cash flows ($152,000 × 2.283) 347,016$
Present value of salvage, due in three years ($20,000 × .658) 13,160
Total present value 360,176$
Less: Amount to be invested 350,000
Net present value of this project 10,176$
TOYING WITH NATURE
Schedule of Estimated Net Income
Payback period:
Depreciation expense [($350,000 – $20,000) ÷ 3] 110,000
Selling and general expenses 55,000 410,000
Income before income taxes 70,000$
Income taxes expense ($70,000 × 40%) 28,000
Estimated increase in annual net income 42,000$
PROBLEM 26.2A
HIBBING TECHNOLOGY
a.
(1)
(3) Net present value, discounted at 12%:
Total present value of eight annual net cash flows ($112,000 × 4.968) 556,416$
Less: Amount to be invested 560,000
(1)
(2)
Return on average investment:
(3) Net present value, discounted at 12%:
Total present value of seven annual net cash flows ($122,500 × 4.564) 559,090$
Present value of salvage value due in seven years ($70,000 × .452) 31,640
Total present value 590,730$
Less: Amount to be invested 490,000
Net present value of proposal 100,730$
b.
25 Minutes, Medium
Proposal B
Proposal A
Payback period:
From the information above, Proposal B clearly appears to be the better investment.
Payback period:
(2)
Return on average investment:
25 Minutes, Medium
PROBLEM 26.3A
WELSH INDUSTRIES
a.
(1)
(3) Net present value, discounted at 10%:
Total present value of five annual net cash flows ($100,000 × 3.791) 379,100$
Present value of salvage value due in five years ($80,000 × .621) 49,680
Less: Amount to be invested 400,000
Net present value of proposal 28,780$
(1)
(2)
$576,000 ÷ $192,000 = 3 years
Return on average investment:
$57,600 ÷ ($576,000 ÷ 2)
$57,600 ÷ $288,000 = 20%
(3) Net present value, discounted at 10%:
Less: Amount to be invested 576,000
Net present value of proposal 260,160$
b.
From the information above, Proposal B clearly appears to be the better investment. It has
Proposal A
Payback period:
Proposal B
Payback period:
(2)
$400,000 ÷ $100,000 = 4 years
Return on average investment:
$36,000 ÷ $240,000 = 15%