Chapter 9
Capital Budgeting and Other Long-Run Decisions
QUESTIONS
2. Time value of money must be considered because the value of money received in
4. With the net present value approach, investments are accepted if the net present
6. Because depreciation reduces taxable income, it results in a tax savings equal to
7. The net present value and internal rate of return methods consider the total stream
of cash flows as well as the time value of money. Meanwhile, the payback method
9. With uneven cash flows, the internal rate of return is calculated using a trial and
error approach. Managers “guess” at the IRR and calculate the present value. If
10. In many cases, the benefits of an investment are difficult to quantify (i.e., there are
Jiambalvo Managerial Accounting
9-2
EXERCISES
E1. [LO 1]
E2. [LO 1, 3]
The NPV is positive and Sally should make the investment.
Time
Cash Flow
10% PV Factor
PV Amounts
Year
Effect on income
ROI
1
$1,550,000
4.43%
2
5.17%
3
6.20%
4
7.75%
5
10.33%
6
15.50%
not defined
Although the project has a positive NPV, if Sally is overly focused on short-term
E3. [LO 1]
E4. [LO 1]
Cash 11% Present Value
E5. [LO 1]
The numbers decrease from left to right in a given row because cash received in
E6. [LO 1]
Cash 15% Present Value
E7. [LO 1]
Plan A
Total
Plan B
Cash 8% Present Value
Flow Factors Total
Plan C
Cash 8% Present Value
E8. [LO 1]
Cash 12% Present Value
Jiambalvo Managerial Accounting
9-4
E9. [LO 1]
The investment should not be undertaken because the internal rate of return of
13.8% is less than the required rate of 18%.
Initial outlay $200,000
E10. [LO 1]
a. Initial outlay $195,000
b. Tanya should make the investment because its return of 12.7% is greater
E11. [LO 2]
Annual depreciation
$90,000 ÷ 5 years $18,000
E12. [LO 2]
Year Income (Loss)
1 ($350,000)
Cash 14% Present Value
Flow Factors Total
E13. [LO 1, 2]
The annual cash inflow is $17,200, calculated as follows:
Revenue $34,000
Less:
Cost other than depreciation 12,000
Cash 14% Present Value
Flow Factors Total
Jiambalvo Managerial Accounting
9-6
E14. [LO 3]
The payback period is 6 years as follows:
E15. [LO 3]
The accounting rate of return is 18%:
Average income $32,000
E16. [LO 1]
As indicated, the NPV is close to zero at a rate of 11%. Thus, the IRR is
approximately 11%. Given that the required rate of return is 14%, the e–
commerce business should not be developed.
Discount rate
11.14%
Time
Cash Flow
Present Value Factor
Total
0
(1,300,000)
1.0000
($1,300,000)
1
0.8998
2
0.8096
3
0.7284
4
0.6554
5
0.5897
Discount rate
11.15%
Time
Cash Flow
Present Value Factor
Total
0
(1,300,000)
1.0000
1
0.8997
2
0.8094
3
0.7282
4
0.6552
5
0.5895
Chapter 9 Capital Budgeting Decisions
9-7
E17. [LO 1]
As indicated below, the NPV is close to zero when using a return of 8 percent.
Thus, the IRR is approximately 8 percent.
Discount rate
8.00%
Time
Cash Flow
Present Value Factor
Total
0
(2,500,000)
1.0000
($2,500,000)
E18. [LO 1]
The online business may help the company manage a potentially stodgy image
associated with its mall locations. Also, the online business may actually
1
2
0.8573
3
0.7938
4
5
Jiambalvo Managerial Accounting
9-8
PROBLEMS
P1. [LO 1, 2] The original contract was worth $15,880,500 in present value terms while
the new offer is worth $13,184,230. When the time value of money is taken into
account, it is obvious that the new offer is not better than the old one.
Cash 15% PV
Time Flow Factors Total
Cash 15% PV
Time Flow Factors Total
1 2,500,000 0.8696 2,174,000
P2. [LO 1]
14%
PV PV
Cash Flow Factors Amounts
Cost of new refrigeration unit
($25,000)
1.0000
($25,000)
5.2161
Annual electricity savings
5.2161
Additional annual maintenance costs
5.2161
Amount collected from disposal of unit
0.2697
($10,342)
Additional annual profit
P3. [LO 1]
13%
Machine A
Cash
Flow
PV
Factors
PV
Amounts
Cost of machine
($70,000)
1.0000
($70,000)
Annual savings
3.9975
Machine B
Cost of machine
($95,000)
1.0000
($95,000)
Annual savings
3.9975
P4. [LO 1]
a. Present value of annual cash flows in Caribbean/Alaska itinerary at 12%
($169,000,000 6.8109) $1,151,042,100
Present value of annual cash flows in Caribbean/Eastern Canada itinerary at
12%
P5. [LO 1, 2]
Year 1 Year 2 Year 3 Year 4
Revenue $16,500,000 $10,000,000 $2,500,000 $1,000,000
Cash 12% PV
Time Flow Factors PV Amounts
0 ($20,000,000) 1.0000 ($20,000,000)
Jiambalvo Managerial Accounting
9-10
P6. [LO 1, 2]
Cash flow per year:
Revenue ($22,000 x 5) $110,000
P7. [LO 1, 2, 3]
a. The net present value is positive $804,663. Thus the company should invest in
the paint and body shop.
Cash 12% Present Value
Flow Factors PV Amounts
b. A present value of an annuity factor of 2.8169 implies the IRR is greater than
30 percent.
Chapter 9 Capital Budgeting Decisions
9-11
c. The payback period is approximately 2.8 years:
d. The accounting rate of return is 51%:
P8. [LO 1]
a. Present value of Machine A
Cash 14% PV
Annual amounts: Flow Factors PV Amounts
Labor saving $25,000
Jiambalvo Managerial Accounting
9-12
b. Present value of Machine B
Cash 14% PV
Annual amounts: Flow Factors PV Amounts
P9. [LO 1, 2]
Drake should invest in the new limousine since the NPV is positive.
Net income $25,320
P10. [LO 1, 2]
Island Ferry should not invest in the boat because the NPV is negative.
Revenue $325,000
Less:
Labor cost 90,000
Cash 10% Present Value
Flow Factors PV Amounts
P11. [LO 1]
Jiambalvo Managerial Accounting
9-14
P12. [LO 1, 3]
a. Revenue (45,000 $30) $1,350,000
Less:
Component cost 370,000
Cash 15% Present Value
Flow Factor PV Amounts
b. The payback period is approximately 3.22 years:
c. The accounting rate of return is 30%:
P13. [LO 1]
Year 1 2 3 4 5 6 7
Income $88,000 149,000 237,200 346,620 436,382 549,720 651,992
Year Cash flow 14% PV Factors PV Amounts
1. $148,000 .8772 $ 129,826
P14. [LO 1, 2]
a. The cost of capital includes an allowance for expected inflation. Thus, in
b. Note that cash flows increase by 4% per year (except for the cash flow related
to the depreciation tax shield).
10% PV
Year Cash flow Factors PV Amounts
1 $ 631,250 .9091 $ 573,869
Jiambalvo Managerial Accounting
9-16
P15. [LO 1]
Note that in problem 14, the NPV was only $226,951 using a 10% required rate
13.7%
Year Cash flow PV Factors PV Amounts
P16. [LO 1]
P17. [LO 3]
a. Richards is evaluated and compensated based on ROI which has some
measure of income in the numerator and a measure of investment in the
b. It will mitigate the problem. If Richards owns a great deal of stock/and or
P18. [LO 1]
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $65,000 $66,300 $78,230 $88,000 $95,238
Less:
12% PV
Year Cash flow Factors PV Amounts
1. $ 11,340 .8929 $ 10,125
2. 9,300 .7972 7,414
Jiambalvo Managerial Accounting
9-18
Case 9-1 [LO 1 and Ethics]
JUNIPER PACKAGING SOLUTIONS, INC.
Summary
Spencer Williams, vice president of a production facility, and the plant controller are
planning on purchasing equipment, although there is a freeze on capital expenditures
greater than $500,000.
Questions to ask students
1. What is the situation of Spencer Williams and Juniper Packaging Solutions?
2. Is it ethical for Spencer and the controller to violate the CEO’s capital expenditure
freeze and cover up their actions by asking vendors to submit multiple invoices
for less than the maximum of $500,000?
Discussion
What is the situation facing Spencer and the controller? They believe that it is
imperative that their company buy new state of the art equipment costing $2 million.
However, the CEO has mandated a freeze on capital expenditures after third-quarter
earnings dropped due to a weakening of the Asian economy and a decreased demand
Other points to consider:
Case 9-2 [LO 1, 2]
SERGO GAMES
Summary
A game company is considering outsourcing manufacturing of CDs.
• The case extends the discussion in the text which focuses on present value
analysis related to investment decisions. This case demonstrates present
Questions to ask students:
1. What is the situation facing Sergo Games?
2. What is your analysis of the situation?
3. What are flaws in Leslie Eastman’s analysis?
Discussion
What is the decision facing Sergo Games? Sergo Games is considering outsourcing the
production of CDs. An analysis by an accounting manager supports outsourcing.
What is your analysis of the situation? The approach we take is to compute the NPV of
Jiambalvo Managerial Accounting
9-20
If Sergo Games chooses not to outsource the production of their CDs, the NPV would
be as follows:
Year
Year
Year
Year
Year
Year
0
1
2
3
4
5
Labor
(900,000)
(900,000)
(900,000)
(900,000)
(900,000)
The NPV for outsourcing is as follows:
Year
Year
Year
Year
Year
Year
0
1
2
3
4
5
Cost of CDs
Tax savings
on losses
700,000
flows
P.V. factor
Net present
value
Total cash
What are the flaws in Leslie Eastman’s analysis? A primary error is that the savings per CD
Material
Supervisor
salaries
(350,000)
(350,000)
(350,000)
(350,000)
(350,000)
Heat, light, etc.
(200,000)
(200,000)
(200,000)
(200,000)
Total cash flows
(3,915,500)
(3,915,500)
(3,915,500)
(3,915,500)
(3,915,500)
P.V. factor
Net present value
(3,527,474)
(3,177,820)
(2,863,014)
(2,579,140)
(2,323,849)