ch11 TB
ch11 TB
ch11 TB
CAPITAL BUDGETING
The following tables are needed to complete problems requiring present value
computations. Students may also use a calculator or computer spreadsheet program, but the
answers to the multiple choice may change due to rounding errors.
Warning: Two comprehensive problems are prefaced by (Additional PV information is needed to
complete this problem.) when these tables are insufficient for completion.
Period
5
10
20
Period
5
10
20
5%
0.7835
0.6139
0.3769
5%
1.2763
1.6289
2.6533
Present value of $1
10%
15%
20%
0.6209
0.3855
0.1486
0.4972
0.2472
0.0611
0.4019
0.1615
0.0261
Future value of $1
10%
15%
20%
1.6105
2.5937
6.7275
2.0114
4.0456
16.3665
2.4883
6.1917
38.3376
TRUE/FALSE
1.
2.
Long-term asset acquisitions are evaluated to determine whether future benefits justify the
initial cost.
a.
True
b.
False
3.
4.
Robert wants to invest in a certificate of deposit that pays out $4,000 in four years. If
interest rates increase, the required initial investment will also increase.
a.
True
b.
False
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5.
6.
7.
8.
The cost of capital reflects the degree of financial and operating risk to the organization.
a.
True
b.
False
9.
If a companys cost of capital is 15%, a net present value of $10 indicates an acceptable
capital project.
a.
True
b.
False
10.
Choosing the greatest net present value is always the best decision choice.
a.
True
b.
False
11.
When using net present value and a 12% discount rate results in an acceptable project, then
a 9% discount rate will also result in that same project being acceptable.
a.
True
b.
False
12.
The net present value method is considered superior to the internal rate of return for
evaluating capital projects.
a.
True
b.
False
13.
The internal rate of return method assumes the organization can reinvest a projects
intermediate cash flows at the projects internal rate of return.
a.
True
b.
False
14.
The payback method does not consider the time value of money and, therefore, is rarely
used in practice.
a.
True
b.
False
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15.
If a companys cost of capital is 12%, a net present value of $1 indicates the projects actual
rate of return exceeds 12%.
a.
True
b.
False
16.
The profitability index provides comparison information for projects with different initial
investments.
a.
True
b.
False
17.
Economic value added is best suited for evaluating new capital projects.
a.
True
b.
False
18.
Depreciation reduces income and, therefore, helps reduce the income taxes of an
organization.
a.
True
b.
False
19.
To account for inflation, discount the cash flow by the appropriate discount rate and the
expected inflation rate.
a.
True
b.
False
20.
Capital budgeting estimates are usually more accurate for new projects.
a.
True
b.
False
21.
If a capital project is projected to return less than the cost of capital, it may still be
implemented for strategic reasons.
a.
True
b.
False
22.
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MULTIPLE CHOICE
23.
24.
At the end of the two years, the future value of the CD is:
a.
$10,000
b.
$10,600
c.
$11,200
d.
$11,236
26.
27.
The difference between the present value and the future value of this investment is:
a.
the annuity of the investment
b.
interest earned on the investment
c.
the investment rate of return
d.
the cash inflows from the investment
28.
For the purchase of a boat, motor, and trailer, Steven needs to accumulate $25,000 at the
end of two years. His initial investment will earn 8% annual interest compounded
semiannually. For this investment:
a.
the number of compounding periods is 2
b.
the interest earned per compounding period is 4%
c.
$25,000 is the present value
d.
the rate of return is 16%
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29.
Investments A and B both have a future value of $5,000 and are exactly the same except that
Investment A has a 5% rate of return while Investment B has an 8% rate of return. The
present value of Investment A will be __________ the present value of Investment B.
a.
less than
b.
the same as
c.
greater than
d.
cant tell
30.
Investments A and B both have a future value of $5,000 and are exactly the same except that
Investment A matures in 5 years while Investment B matures in ten years. The present value
of Investment A will be __________ the present value of Investment B.
a.
less than
b.
the same as
c.
greater than
d.
cant tell
31.
A lottery pays the winner $100,000 per year for 20 years. The present value of this prize
money is:
a.
greater than $2,000,000
b.
$2,000,000
c.
less than $2,000,000
d.
indeterminable
32.
34.
Assume interest rates increase before the investment is made. To reach the same goal of
$25,000 in 25 years, the investor will have to deposit:
a.
more than $5,000
b.
$5,000
c.
less than $5,000
d.
More information is needed to determine the amount of the deposit.
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35.
You have been offered the following two annuities for the same price: Annuity 1 pays
$20,000 per year for 10 years; and Annuity 2 pays $40,000 per year for 5 years. Which of
these two annuities offers a greater value?
a.
They are of equal value because both pay $200,000 over the life of the annuity.
b.
Annuity 2 is of greater value because the payments are received sooner.
c.
Annuity 1 is of greater current value because the payments are received over a longer
period of time.
d.
The value cannot be determined without proper present value analysis.
What is the present value of the $10,000 payment at the end of the tenth year?
a.
$ 1,486
b.
$ 3,769
c.
$ 3,855
d.
$61,446
37.
38.
39.
What would an investor be willing to pay now for this $10,000 bond?
a.
More than $10,000
b.
$10,000
c.
Less than $10,000
d.
More information is needed to determine the amount.
40.
All of the following use the time value of money to evaluate long-term investments
EXCEPT:
a.
the payback method
b.
the net present value method
c.
the internal rate of return
d.
the profitability index
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41.
Assume a capital project requires $42,000 as an initial investment and expects a net cash
inflow of $12,000 per year. The payback period method:
a.
would consider the capital project acceptable if the company requires a minimum
payback period of three years
b.
is usually used as a screening device to eliminate capital projects from further
investigation
c.
uses accounting net income rather than cash flows in the calculations
d.
compares the rate of return to the companys cost of capital
42.
43.
44.
45.
Project A: present value (PV) of the cash inflows is $55,000 and the PV of the cash
outflows is $50,000. Project B: PV of the cash inflows is $24,000 and the PV of the cash
outflows is $20,000. All of the following are true EXCEPT:
a.
the net present value of Project A is $5,000
b.
the net present value of Project B is $4,000
c.
the profitability index for Project A is 1.1
d.
Project A is a better investment than Project B
46.
A 16% internal rate of return (IRR) indicates all of the following EXCEPT:
a.
the actual rate of return of all cash inflows and outflows
b.
that a 16% discount rate will result in the calculation of a net present value of zero
c.
a better indication of acceptable capital projects when there is limited capital than the
net present value method
d.
an acceptable capital project if the cost of capital is 12%
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47.
48.
49.
50.
Hitz Corporation is financed 60% by debt with a pretax cost of 10%, and 40% by common
equity with a pretax cost of 15%. Hitz Corporations marginal tax rate is 50%. Hitzs
weighted average cost of capital is:
a.
9.0%
b.
10.0%
c.
12.0%
d.
12.5%
Investment 1
$110,000
$ 20,000
10 years
0
Investment 2
$170,000
$ 30,000
10 years
0
Determine the present value of the initial investment for each alternative.
a.
$42,405 and $65,535
b.
$675,906 and $1,044,582
c.
$1,700,000 and $1,100,000
d.
None of the above is correct.
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52.
Determine the present value of the annual cash flows for each alternative.
a.
$7,710 and $11,565
b.
$20,000 and $30,000
c.
$122,892 and $184,338
d.
$200,000 and $300,000
53.
54.
55.
57.
Using the net present value criterion, which is the most desirable project?
a.
Project A
b.
Project B
c.
Both projects A and B are equally acceptable.
d.
The desirability cannot be determined using the current information.
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59.
Which single investment do you recommend of these three mutually exclusive projects?
a.
investment 1
b.
investment 2
c.
investment 3
d.
All of these investments could be recommended.
61.
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62.
Assuming a 10 % required rate of return, the net present value for one franchise-owned
restaurant is:
a.
$19,275
b.
$11,565
c.
($65,662)
d.
$57,230
63.
64.
65.
67.
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68.
Assuming a 10 % required rate of return, the net present value for one franchise-owned
restaurant is:
a.
$7,710
b.
$260,845
c.
($377,108)
d.
($39,155)
69.
70.
71.
72.
Taxes of an organization:
a.
are increased as a result of depreciation
b.
affect lump-sum payments but not annuities
c.
can best be analyzed by using pretax cash flows
d.
usually increase when the net benefit of an investment increases
73.
All of the following are true regarding capital budgeting EXCEPT that:
a.
estimates are not always realized
b.
estimating future cash flows is relatively easy
c.
most estimates are extended projections of past cash flow information
d.
estimating circumstances not previously experienced is the hardest
74.
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75.
Strategic considerations:
a.
are fairly easy to determine
b.
evaluate a firms competitive edge
c.
should not override capital budgeting analysis results
d.
are decreasing in importance
76.
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REMINDER!!! Present value tables that are needed to answer the multiple choice questions
are located at the beginning of this chapter.
EXERCISE/PROBLEM
77.
An investor wants to have $20,000 in an account at the end of 20 years. At current interest
rates, $7,000 needs to be deposited now to reach the goal of $20,000.
a.
What is the present value of this investment?
b.
Assume interest rates decrease before the investment is made. Will an investment of
$7,000 still result in $20,000 in 20 years? Why or why not?
78.
You have been offered the following two annuities for the same price: Annuity 1 pays
$50,000 per year for 10 years; and Annuity 2 pays $25,000 per year for 20 years. Which of
these two annuities is a better deal? Why?
79.
80.
A bond with a face value of $25,000 pays $1,000 in interest every six months for 10 years
and a lump sum of $25,000 at the end of the tenth year. The current market requires 10%
interest compounded semiannually.
a.
What would an investor be willing to pay now for
1.
the $25,000 at the end of the tenth year?
2.
the $1,000 semiannual interest payments?
3.
the $25,000 bond?
b.
Is this bond selling at a premium or a discount? Why?
81.
Hitz Corporation is financed 70% by debt with a pretax cost of 10%, and 30% by common
equity with a pretax cost of 18%. Hitz Corporations marginal tax rate is 40%.
a.
Calculate Hitzs weighted average cost of capital.
b.
How might the cost of capital be used for decision making at Hitz Corporation?
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82.
83.
Stevens Company is contemplating the purchase of a corporate jet. This jet could be either
purchased or rented from the manufacturer. The length of the purchase contract is five
years. If the jet is purchased, Stevens could sell it at the end of five years for $600,000. The
companys cost of capital is 20%. The data concerning these two alternatives are as follows:
Purchase
Rent
Purchase price
$820,000
-Annual cash payments for servicing and licenses
40,000
-Depreciation each year
44,000
-Salvage value at the end of year 5
600,000
-Estimated annual rental payments
-$250,000
a.
b.
84.
Determine the present value of the initial investment for each alternative.
Determine the present value of the annual cash flows for each alternative.
Compute the net present value for each investment.
Compute the profitability index for each investment.
Which investment would you recommend? Why?
$65,000
$40,000
5 years
0
Assuming the company uses straight-line depreciation for tax purposes, what is the net
present value of purchasing the new equipment, taking income taxes into account?
Should Roberts consider this purchase? Why or why not?
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85.
Consider the following two mutually exclusive projects, each of which require an initial
investment of $100,000 and have no salvage value. This organization, which has a cost of
capital of 15%, must choose one or the other.
Year
1
2
3
4
5
a.
b.
c.
d.
e.
86.
Project A
$10,000
20,000
30,000
40,000
50,000
Project B
$50,000
40,000
30,000
20,000
10,000
Compute the payback period of these two projects. Using the payback criterion,
which project is more desirable?
What are the advantages and drawbacks of using the payback period criterion to select
a capital investment alternative?
Straight-line depreciation is used to compute income. Compute the accounting rate of
return for these two projects. Using the accounting rate of return criterion, which
project is more desirable?
What are the advantages and drawbacks of using the accounting rate of return
criterion to select a capital investment alternative?
Which is the better investment? Why?
e.
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87.
88.
payback;
accounting rate of return (assuming straight-line depreciation);
net present value; and
internal rate of return.
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CRITICAL THINKING/ESSAY
89.
90.
Some people believe that discounted cash flow analysis discriminates against long-term
projects because it heavily penalizes cash flows that occur well into the future. Comment.
91.
Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%
discount rate to evaluate capital project XYZ?
92.
Explain the profitability index and the payback methods used in capital budgeting. Discuss
when it would be most appropriate to use each.
93.
List two capital budgeting methods that utilize the time value of money and explain how
each ranks the performance of different alternatives.
94.
Explain how the internal rate of return criterion, if improperly applied, can cause managers
to make inappropriate investment decisions.
95.
You are considering an investment in a new restaurant chain. You have developed estimates
of the initial investment required and the cash flows from that investment. However, you
are wondering about the risk of your investment. How might you assess the impact of
estimates in your investment decision?
96.
97.
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98.
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CHAPTER 11
SOLUTIONS
CAPITAL BUDGETING
TRUE/FALSE
MULTIPLE CHOICE
LO1
LO3
LO3
LO3
LO3
1.
2.
3.
4.
5.
a
a
b
b
a
LO3
LO3
LO3
LO4
LO4
6.
7.
8.
9.
10.
b
b
a
a
b
LO4
LO4
LO4
LO4
LO4
11.
12.
13.
14.
15.
b
a
a
b
a
LO4
LO4
LO5
LO5
LO6
16.
17.
18.
19.
20.
a
b
a
a
b
LO7
LO8
21.
22.
a
a
LO1
LO2
LO3
23.
24.
25.
b
c
d
LO3
LO3
LO3
LO3
LO3
26.
27.
28.
29.
30.
a
b
b
c
c
LO3
LO3
LO3
LO3
LO3
31.
32.
33.
34.
35.
c
a
b
c
b
LO3
LO3
LO3
LO3
LO4
36.
37.
38.
39.
40.
b
a
d
a
a
LO4
LO4
LO4
LO4
LO4
41.
42.
43.
44.
45.
b
d
b
a
d
LO4
LO4
LO4
LO4
LO4
46.
47.
48.
49.
50.
c
c
d
b
a
Chapter 11
Page 20
LO4
LO4
LO4
LO4
LO4
51.
52.
53.
54.
55.
d
c
a
b
c
LO4
LO4
LO4
LO4
LO4
56.
57.
58.
59.
60.
a
a
c
b
a
LO4
LO4
LO4
LO4
LO4
61.
62.
63.
64.
65.
b
d
c
a
c
LO4
LO4
LO4
LO4
LO4
66.
67.
68.
69.
70.
a
b
d
c
a
LO4
LO5
LO6
LO6
LO7
71.
72.
73.
74.
75.
c
d
b
a
b
LO8
76.
Schoenebeck
MULTIPLE CHOICE
25.
36.
38.
45.
50.
Pretax cost
Debt
10%
Common equity
15%
Weighted average cost of capital
51.
52.
53.
54.
56.
57.
58.
59.
60.
61.
62.
63.
64.
66.
67.
68.
69.
70.
Chapter 11
Page 21
Weight
60%
40%
Weighted average
3.0%
6.0%
9.0%
Schoenebeck
EXERCISE/PROBLEM
LO3
77. a.
b.
LO3
78. Even though both annuities pay $500,000 in total, Annuity 1 is the better deal because the
total payback of $500,000 is received 10 years earlier.
LO3
79. a.
b.
c.
LO3
80. a1.
a2.
a3.
b.
No, the lottery winner is not receiving a $1,000,000 value because the entire sum is
not being received now. Because money can earn a return, its value depends on when
it is received.
Yes, this is an annuity because the winner is receiving the same amount at the end of
each year for 20 years.
The present value of the prize money is $623,110 = ($50,000 x 12.4622). This
indicates that the 20 payments of $50,000 each to be received in the future are only
worth $623,110 now, rather than $1,000,000.
Present value of the $25,000 at the end of ten years is $9,423 = $25,000 x 0.3769.
Present value of the $1,000 semiannual interest payments is $12,462 = $1,000 x
12.4622.
Present value of the $25,000 bond is $21,885 = ($9,423 + $12,462).
This bond is selling at a discount because the bond is only paying 8% ($2,000 per
year / $25,000 face) interest when the market rate is 10%. To achieve the higher yield,
the investor pays in less than face value (discounted), but at maturity the investor
receives the full $25,000 face value.
LO3
81. a.
Pretax cost
Debt
10%
Common equity
18%
Weighted average cost of capital
b.
Weight
70%
30%
Weighted average
4.2%
5.4%
9.6%
Hitz Corporation may use the cost of capital as a benchmark for accepting or rejecting
capital investment proposals.
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LO4
82.
a.
b.
c.
d.
e.
Investment 1
PV of the initial investment
$210,000
PV of the annual cash flows
$227,448 = ($60,000 x 3.7908)
Net present value $17,448 = ($227,448 $210,000)
Profitability index 1.083 = ($227,448 / $210,000)
Investment 2
$135,000
$151,632 = ($40,000 x 3.7908)
$16,632 = ($151,632 $135,000)
1.123 = ($151,632 / $135,000)
The profitability index indicates that Investment 2 is preferred, while the net present
value method does not inherently distinguish between projects with different
magnitudes of initial investment. However, the final choice between these two
mutually exclusive alternatives may depend on qualitative factors that distinguish
between the two alternatives or identify other possible uses for the available funds.
LO4
83.
a.
Item
Amount
Purchase (820,000)
Services (40,000)
Salvage
600,000
Item
Rent
Amount
(250,000)
b. Net present value indicates that purchasing the jet is the preferred alternative. However,
even though the net present values differ by $49,166, the additional risk of ownership may
sway the company to choose to rent on a use-by-use basis.
LO5
84. a.
The net present value is $45,691 when income taxes are taken into account.
Annual cash flow Depreciation Taxable income
$40,000
$13,000
$27,000
After-tax net cash flow
Initial investment
Annual cash flows
$29,200
Net present value
b.
Tax @ 40%
$10,800
PV factor of an annuity
Present value
($65,000)
110,691
($45,691)
Yes, Roberts should consider this purchase because the net present value is positive,
which indicates the purchase meets the companys 10% cost of capital requirement.
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LO4
85. a.
b.
The advantage of using the payback period criterion is that it gives an indication of the
projects risk, in the sense that the longer the payback period, the longer an
organization is exposed to an unrecovered investment. Drawbacks include that it
ignores the time value of money and that it ignores cash outflows after the initial
investment and cash inflows after the payback period.
c.
d.
e.
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LO4
86. a.
----1---Present value of cash inflows
at a 10% discount rate
$56,727
Initial investment
(48,000)
Net present value
$ 8,727
b.
Profitability index
-------1------- -------2------1.18 = 56,727 1.20 = 43,340
48,000
36,000
----2---$43,340
(36,000)
$ 7,340
----3---$33,614
(27,000)
$ 6,614
-------3-----1.24 = 33,614
27,000
----4---$52,297
(45,000)
$ 7,297
-------4------1.16 = 52,297
45,000
----5---$37,976
(40,000)
$ (2,024)
-------5------0.95 = 37,976
40,000
c.
d.
1.
2.
3.
e.
The profitability index indicates that Investment 3 is preferred, the internal rate of
return indicates that Investment 4 is preferred, while the net present value method
does not inherently distinguish between projects with different magnitudes of
investment. However, because the profitability index is considered superior to the
internal rate of return, I would recommend Investment 3. The final choice may depend
on qualitative factors that distinguish the four alternatives.
Net present value is unable to rank projects with different initial investments.
Profitability ranking from highest to lowest is
3 2 1 4 5
Internal rate of return ranking from highest to lowest is 4 3 1 2 5
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LO4
87. (Additional PV information is needed to complete this problem.)
a.
Payback period is 1.58 years =
$244,000 amount invested
.
$154,000 expected annual net cash inflow
b.
Accounting rate of return is 1.05 = $128,000 average annual operating income from asset
[($244,000 + 0) / 2] average amount invested in asset
c.
Present value of annuity of equal net cash inflows for ten years assuming a 16% required
rate of return $154,000 x 4.833 = .............$744,282
Investment.......................................................(244,000)
Net present value........................................$500,282
d.
$244,000 investment
= 1.58 annuity present value factor
$154,000 expected annual net cash inflow
A 1.58 annuity PV factor indicates an Internal rate of return of more than 50% for a tenyear investment.
e.
Yes, a Papa Johns company-owned restaurant appears to be a good investment because the
average payback period is less than two years, the average annual accounting rate of return
is over 100%, the investment more than delivers the 16% required rate of return, and the
internal rate of return is over 50%.
LO4
88. (Additional PV information is needed to complete this problem.)
a.
The total initial investment, over the two years, is $24,000,000. The after-tax cash
flows, as shown in the following exhibits are $4,100,000 per year. Therefore, the
payback period, after the two-year initial investment period, is 5.85 years
($24,000,000/$4,100,000).
b.
The initial investment is $24,000,000 and there is no salvage value. Therefore, the
average investment is $12,000,000 ($24,000,000/2). The machine has a 12-year life,
therefore the annual depreciation is $2,000,000. The annual taxes are $900,000 as
showing in the following exhibits. Thus, the annual after-tax accounting income is
$2,100,000 ($5,000,000 - $2,000,000 - $900,000). As a result, the accounting rate of
return is 17.5% ($2,100,000/$12,000,000).
c.
The net present value of this investment is ($252,737), as shown in the following
exhibits.
d.
The internal rate of return of this investment is approximately 11.8%, as shown in the
following exhibits.
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EXHIBIT 1
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
EXHIBIT 2
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Investments
(14,000,000)
(10,000,000)
Taxes
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
Operating
Cash Flows
Depreciation
Taxable
Income
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
Cash Flows
(14,000,000)
(10,000,000)
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
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Present Value
@ 12%
(14,000,000)
(8,928,571)
3,268,495
2,918,299
2,605,624
2,326,450
2,077,188
1,854,632
1,655,921
1,478,501
1,320,090
1,178,652
1,052,368
939,614
(252,737)
Present Value
@ 11.8%
(14,000,000)
(8,944,544)
3,280,199
2,933,989
2,624,319
2,347,334
2,099,583
1,877,981
1,679,768
1,502,476
1,343,896
1,202,054
1,075,183
961,702
(16,059)
Schoenebeck
CRITICAL THINKING/ESSAY
LO1
89. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate
investments in long-term assets. Why do these assets deserve this attention?
Solution: Long-term assets commit the organization to a technology or a process for long
periods of time, creating a technological risk for the organization, and they can usually only
be reversed at great cost. The investment in long-term assets is usually the largest that an
organization makes, creating financial risk for the organization.
LO3
90. Some people believe that discounted cash flow analysis discriminates against long-term
projects because it heavily penalizes cash flows that occur well into the future. Comment.
Solution: Discounted cash flow analysis penalizes cash flows that occur into the future to
recognize the time value of money. For example, with a discount rate of 10%, a cash flow
received 10 years from now is discounted to about 39% of its future value. This is a big
penalty, however, it recognizes the time value of money and the real effect of investing in
long-term assets.
LO4
91. Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%
discount rate to evaluate capital project XYZ?
Solution: The discount rate is adjusted for the level of risk involved with the project. The
higher the discount rate used, the higher the level of risk for the project.
LO4
92. Explain the profitability index and the payback methods used in capital budgeting. Discuss
when it would be most appropriate to use each.
Solution: The profitability index compares the present value of all future cash inflows with
the present value of all future cash outflows. The discount rate allows for various amounts
of risk. This is the most comprehensive capital budgeting analysis tool and it is used to
evaluate the acceptability of a project and to rank projects.
The payback method uses the time to recover the initial investment as a measure of risk. It is
easy to use but because this method does not utilize the time value of money, its use is
usually limited to screening out unacceptable projects.
LO4
93. List two capital budgeting methods that utilize the time value of money and explain how
each ranks the performance of different alternatives.
Solution: Two capital budgeting methods that utilize the time value of money are the net
present value (NPV) method and the internal rate of return (IRR) method. The profitability
index is used to rank the performance of capital projects evaluated using the NPV method.
The IRR percentages can be used to rank the performance.
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LO4
94. Explain how the internal rate of return criterion, if improperly applied, can cause managers
to make inappropriate investment decisions.
Solution: Suppose that an organization's cost of capital is 12% and that a decision maker has
been told that she will be rewarded based on the return on investment of the assets under her
control. The manager will be motivated to make return on investment as high as possible.
Therefore, investments that provide a return on investment that is lower than the current
average will be rejected, even though they may exceed the organization's cost of capital. The
problem with return on investment is that it is improperly used for motivational purposes.
LO6
95. You are considering an investment in a new restaurant chain. You have developed estimates
of the initial investment required and the cash flows from that investment. However, you are
wondering about the risk of your investment. How might you assess the impact of estimates
in your investment decision?
Solution: One approach is to use sensitivity analysis. In this approach, the investor would
vary the cash flow estimates to identify how sensitive the decision to invest is to the
estimated cash flows. If the decision is very sensitive, that is, a 5-10% decrease in cash
flows would shift the investment decision from positive to negative, then the investor might
want to take steps to improve the reliability of the forecasts or not invest in the project.
LO7
96. An organization is considering investing in an employee-training program. The
organization's planners expect that this training program, which would cost $5,000,000, will
reduce manufacturing costs and increase the quality of the company's various products.
How would you frame this decision in the capital budgeting context?
Solution: If this project is to be evaluated using a capital budgeting tool, the organization
will have to quantify the expected benefits of the training program. This may be difficult to
do and, because of this, many organizations make investments like this as an act of faith that
the benefits will exceed the costs.
LO8
97. An organization's planners have received a proposal from a manufacturing group to invest in
a new production line. The planners are suspicious that the proposal reflects the group's
interest in acquiring the latest technology rather than reflecting sound economic evaluation.
How might the planners deal with this situation?
Solution: A common tool is to inform people proposing capital investments that the
organization will perform post-implementation audits on all investment projects to identify
whether benefits were as claimed and, if not, why not. Because this imposes risk on the
people who propose projects, post-implementation audits dampen enthusiasm for all project
proposals, not simply those that reflect non-economic considerations. Therefore, the
organization must make it clear that the post-implementation audits will try to ensure that
the audits are undertaken fairly with due consideration of events that would have been
unforeseeable when the project was proposed.
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LO8
98. Officials at Dundas Manufacturing have just completed a post-implementation audit of a
distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group
had proposed the warehouse investment arguing that it would improve sales by increasing
product quality and improving customer service. The expected rate of return on this
investment was 18%, however, the actual return on this investment to date has fallen far
below this estimate and it is even below the company's cost of capital of 11%. The postimplementation audit concluded that the managers proposing this investment were
ambitious, to the point of being reckless, in making the estimates underlying the project's
proposals and argued that the investment should never have been made.
In response, the two managers who proposed the project argue that the proposal was a
good one based on estimates that seemed sound at the time. However, several
uncontrollable events, including the entry of a new competitor into the market, caused
results to be lower than expected. Moreover, the two managers argue that results would
have been even worse for the company if the investment had not been made. How would
you deal with this situation?
Solution: This situation reflects the critical issue in interpreting a situation where events
were not as expected. The argument hinges on two things. First, it is unreasonable to expect
managers to be responsible for things beyond their control -- what is often called the
controllability principle in management accounting. Second, the events that occurred in this
situation were beyond the managers' control.
Many people believe that the controllability principle is fundamental because it appeals to a
common sense of fairness, namely that people should only be held accountable for what they
do or control. However, some people have argued that making people accountable for
whatever happens motivates them to search for ways to gain control over their environment.
Therefore, while rejecting the controllability principle at first seems harsh and conflicting
with a common view of equity, there may be good behavioral reasons for doing this.
However, for the sake of discussion here, let us assume that the controllability principle is
applied. There are two issues in this case: first, whether or not these managers should
reasonably have anticipated the arrival of the new competitors and second, what would the
results of the new competitor have been if the organization had not built the new warehouse.
These issues are problematic and would have to be resolved by reference to the facts in the
particular situation including what other competitors were doing, public announcements by
the competitor, and what analysts who were following this market were writing and saying.
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