Professional Documents
Culture Documents
Time is money is an apt phrase for the evaluation of capital investment projects. A
cash flow today is not economically equivalent to a cash flow in the future. Since
cash received now can be invested for some rate of return, a dollar received now is
more valuable than a dollar received in the future.
16.2
16.3
This statement is false. As the discount rate increases, the present value of a future
cash flow decreases. A higher discount rate means a higher return on funds that are
invested now. If funds invested now can earn a greater return, it is even more
important to have the funds now, instead of in the future, than it is if the rate of
return is lower. Therefore, the greater the discount rate, or rate of return on invested
funds, the lower will be the present value of any future cash flow.
16.4
16.5
(1) The decision rule used to accept or reject an investment proposal under the netpresent-value method is stated as follows: Accept the proposal if the net present
value is zero or positive.
(2) The decision rule used to accept or reject an investment proposal under the
internal-rate-of-return method is as follows: Accept the investment proposal if its
internal rate of return is equal to or greater than the hurdle rate.
16.6
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return. Part of the cash flow from the investment each period provides that return,
and part of the cash flow from the investment provides a partial recovery of the initial
investment.
16.7
16.8
16.9
In the total-cost approach, every cash flow for each project under consideration is
included at its total amount. In the incremental-cost approach, differences are
calculated for each cash flow between the projects under consideration, and the net
present value of these incremental amounts becomes the focus of the analysis.
16.10 In a postaudit of an investment project, information is gathered about the actual cash
flows generated by the project. Then the projects actual net present value or internal
rate of return is computed. Finally, the projections made for the project are
compared with the actual results.
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SOLUTIONS TO EXERCISES
EXERCISE 16-24 (15 MINUTES)
Acquisition cost of site (time 0) ................................................................................
Preparatory work (time 0) ..........................................................................................
Total cost at time 0 .....................................................................................................
Present value of annual savings in operating costs: ($48,000 7.360*) ...............
Net present value .......................................................................................................
$(234,000)
(88,080)
$(322,080)
_353,280
$ 31,200
$234,000
88,080
$322,080
Find 6.710 in the 10-year row of Table IV in Appendix A. This annuity discount factor falls in
the 8 percent column. Thus, the projects internal rate of return is 8 percent. The board
should approve the new landfill because the projects internal rate of return is higher than
the hurdle rate of 6 percent.
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10
$322,080a $299,846b $275,834 $249,901 $221,893 $191,644 $158,976 $123,694 $85,590 $44,437
48,000
48,000
48,000 48,000 48,000 48,000 48,000 48,000 48,000 48,000
25,766
23,988
22,067
19,992
17,751
15,332
12,718
6,847
3,555
22,234
24,012
25,933
28,008
30,249
32,668
35,282
38,104 41,153
44,445
299,846
275,834
85,590 44,437
(8)e
Initial cash outflow: land cost of $234,000 plus preparation cost of $88,080.
In years 2 through 10, the row (1) amount is from row (5) of the previous column.
c
The projects internal rate of return is 8%, as calculated in the preceding exercise.
d
Amounts are rounded.
e
The remainder is due to accumulated rounding errors.
b
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9,896
Repair Costs
Avoided by
Overhaul
3,000 euros
3,000 euros .909a
3,000 euros .893
3,000 euros .877
10%
12%
14%
2,727euros
2,679 euros
2,631 euros
5,000 euros
5,000 euros .826b
5,000 euros .797
5,000 euros .769
Cost of overhaul
(time 0)
Net present value
4,130 euros
3,985 euros
3,845 euros
(6,664 euros )
193 euros
(6,664 euros )
(6,664 euros )
(188 euros )
The internal rate of return of the overhaul is 12 percent, because the projects net present
value is zero when a 12 percent discount rate is used.
EXERCISE 16-28 (30 MINUTES)
Answers will vary widely, depending on the project selected.
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Annuity
Discount
Factor*
5.747
5.335
4.968
4.639
4.344
Annual
Savings
$27,000
27,000
27,000
27,000
27,000
Present Value
of
Annual
Savings
$155,169
144,045
134,136
125,253
117,288
Acquisition
Cost
$129,750
129,750
129,750
129,750
129,750
Net
Present
Value
$25,419
14,295
4,386
(4,497)
(12,462)
Net present value = (annuity discount factor annual savings) acquisition cost.
Notice that the net present value in the right-hand column declines as the discount rate
increases. A higher discount rate means greater urgency associated with having each cash
flow earlier rather than later.
2. The electronic version of the Solutions Manual BUILD A SPREADSHEET SOLUTIONS
is available on your Instructors CD and on the Hilton, 8e website:
WWW.MHHE.COM/HILTON8E.
EXERCISE 16-30 (15 MINUTES)
The annuity discount factor in Table IV of the Appendix (for r = 12% and n = 8) is 4.968. The
theaters board of directors will be indifferent about replacing the lighting system if its net
present value is zero.
Net present value
annuity
annual acquisition
discount factor
cost
savings
Rounded
(b)
(c)
2.
3.
4.
5.
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*Straight-line depreciation with the half-year convention: Half the straight-line percentage of 33.33% in years 1 and 4.
**Rounded.
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Book value
2.
3.
$855
9,255
$10,110
12%
$32,208
$29,496
$27,120
$32,208
$30,000
$29,496
$30,000
$27,120
$30,000
1.07
.98
.90
Profitability index =
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Payback period =
=
2.
initial investment
annual after - tax cash flow
$124,200
$27,000
= 4.6 years
Net-present-value analysis:
Discount Rate
10%
12%
Present value of after-tax savings:
$27,000 4.868* ..............................................
$27,000 4.564* ..............................................
$27,000 4.288* ..............................................
Initial investment .................................................
Net present value ................................................
14%
$131,436
$123,228
(124,200)
$7,236
(124,200)
$(972)
$115,776
(124,200)
$ (8,424)
Conclusion: The automatic teller machines are a sound economic investment if the
after-tax hurdle rate is 10 percent, but not if it is 12 percent or 14 percent. The payback-period criterion fails to account for the time value of money. If management
uses the payback method, the investment will be approved if the required payback
period is 4.6 years or more. Otherwise the investment will be rejected. However,
setting the cut-off value for the payback period has nothing to do with the banks
hurdle rate. In summary, the net-present-value method is preferable to the payback
method.
McGraw-Hill/Irwin
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2.
3.
$19,000
$105,000
= 18.1% (rounded)
After-Tax
Cash Flow
$(105,000)
50,000
45,000
40,000
35,000
30,000
Discount
Factor*
1.000
.862
.743
.641
.552
.476
Present
Value
$(105,000)
43,100
33,435
25,640
19,320
14,280
$30,775
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Cash Flow
in Real
Dollars
$(150,000)
45,000
45,000
45,000
45,000
45,000
45,000
45,000
45,000
Discount Factor*
(real interest rate = .20)
1.000
.833
.694
.579
.482
.402
.335
.279
.233
Present
Value
$(150,000)
37,485
31,230
26,055
21,690
18,090
15,075
12,555
10,485
$22,665
=($45,000)(3.837) $150,000
=$22,665
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.20
.10
.02
.32
2.
(2)
Cash Flow
in
Real
Dollars*
Year
0
$(150,000)
1
45,000
2
45,000
3
45,000
4
45,000
5
45,000
6
45,000
7
45,000
8
45,000
Net present value
(1)
(3)
Price
Index
1.0000
(1.10)1 = 1.1000
(1.10)2 = 1.2100
(1.10)3 = 1.3310
(1.10)4 = 1.4641
(1.10)5 = 1.6105
(1.10)6 = 1.7716
(1.10)7 = 1.9487
(1.10)8 = 2.1436
(4)
(5)
Cash Flow in
Discount
Nominal
Factor
Dollars
(nominal interest
rate = .32)
[Col. (2) Col. (3)]
$(150,000)
1.000
49,500
.758
54,450
.574
59,895
.435
65,885
.329
72,473
.250
79,722
.189
87,692
.143
96,462
.108
(6)
Present
Value
[Col. (4)
Col. (5)]
$(150,000)
37,521
31,254
26,054
21,676
18,118
15,067
12,540
10,418
$22,648
Net present value = $22,648. See the preceding table. The $17 difference between the
NPVs computed in this and the preceding exercise is due to the accumulated
rounding errors in the price indexes and discount factors.
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SOLUTIONS TO PROBLEMS
PROBLEM 16-40 (30 MINUTES)
1.
Yes. This is a long-term decision, with cash flows that occur over a five-year period.
Given that the cash flows have a value dependent on when they take place (e.g.,
cash inflows that occur in earlier years have a higher time value than cash inflows
that take place in later years), discounting should be used to determine whether
Community Challenges should outsource.
2.
$(24,000,000)
(95,000)
$(24,095,000)
x
3.433
$(82,718,135)
(60,000)
(8,037)
6,228
$(82,779,944)
The company would be financially indifferent if the net present value (NPV) of the
manufacture alternative equals the NPV of the outsource alternative. Thus:
Let X = purchase price
3.433 x 400,000X = $82,779,944
1,373,200X = $82,779,944
X = $60.28 (rounded)
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Year 1
Year 2
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
$(80,000) $(80,000) $(80,000) $(80,000) $(80,000) $(80,000) $(80,000) $(80,000) $(80,000) $(80,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(400,000)
(100,000)
$(580,000)
.893
$(517,940)
(100,000)
$(580,000)
.797
$(462,260)
(100,000)
$(580,000)
.712
$(412,960)
(100,000)
$(580,000)
.636
$(368,880)
(100,000)
$(580,000)
.567
$(328,860)
(100,000)
$(580,000)
.507
$(294,060)
(100,000)
$(580,000)
.452
$(262,160)
(100,000)
$(580,000)
.404
$(234,320)
(100,000)
$(580,000)
.361
$(209,380)
(100,000)
$(580,000)
.322
$(186,760)
Sum= $(3,277,580)
Year 3
$(30,000) $(30,000) $(30,000) $(30,000) $(30,000) $(30,000) $(30,000) $(30,000) $(30,000) $(30,000)
$(625,000)
(300,000)
(200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000)
(50,000) (50,000)
(50,000)
(50,000)
(50,000)
(50,000)
(50,000)
(50,000)
(50,000)
(50,000)
(250,000) (250,000)
$(625,000)
1.000
$(625,000)
100,000
$(430,000)
.893
$(383,990)
(250,000)
(250,000)
100,000 100,000
$(430,000) $(430,000)
.797 .712
$(342,710) $(306,160)
100,000
$(730,000)
.636
$(464,280)
(250,000)
(250,000)
(250,000)
100,000 100,000
$(430,000) $(430,000)
.567 .507
$(243,810) $(218,010)
100,000
$(430,000)
.452
$(194,360)
Sum = $ ( 3, 245,730 )
$
(250,000)
(250,000)
100,000 100,000
$(430,000) $(430,000)
.404 .361
$(173,720) $(155,230)
(250,000)
100,000
$(430,000)
.322
$(138,460)
(31,850)
*Table III in Appendix A: r = .12. The lab will be operated at capacity, 25,000 tests per year. **The excess capacity (5,000 tests annually) will be provided to private physicians for a fee.
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$(30,000)
(200,000)
(50,000)
(250,000)
100,000
$(430,000)
80,000
400,000
$ 50,000
100,000
$ 150,000
5.650
$ 847,500
625,000
190,800
$31,700*
*The difference between $31,700 computed in this problem and $31,850 computed in
the preceding problem is due to rounding error when the annuity discount factor is
used.
A tabular presentation of the incremental cost approach, along the lines of Exhibit
16-5, would be more cumbersome than necessary given the equivalent annual cash flows
(excluding the equipment purchases).
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2.
3.
4.
The administrator should recommend that the clinic be built, because its net present
value is positive.
5.
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Sum=$239,410
Old machine:
Annual costs:
Variable 300,000 $.38 .....................................................
Fixed ...................................................................................
Total ...................................................................................
Annuity discount factor (r = 16%; n = 6) ..............................
Present value of annual costs ..............................................
Salvage value, December 31, 20x6 .......................................
Discount factor (r = 16%; n = 6) ............................................
Present value of salvage value .............................................
Net present value ...................................................................
$(114,000)
(21,000)
$(135,000)
3.685
$(497,475)
$7,000
.410
2,870
$(494,605)
New machine:
Annual costs:
Variable 300,000 $.29 .....................................................
Fixed ...................................................................................
Total ...................................................................................
Annuity discount factor (r = 16%; n = 6) ..............................
Present value of annual costs ..............................................
Salvage value of new machine, December 31, 20x6 ...........
Discount factor (r = 16%; n =6) .............................................
Present value of new machines salvage value ..................
Salvage value of old machine, December 31, 20x0 .............
Acquisition cost of new machine .........................................
Net present value ...................................................................
$(87,000)
( 11,000)
(98,000)
3.685
$(361,130)
$20,000
.410
8,200
40,000
(120,000)
$(432,930)
Conclusion: Purchase the new machine because the net present value of relevant
costs is lower than with the old machine.
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Memorandum
Date:
Today
To:
From:
I.M. Student
The lower operating costs (variable and fixed) of the new machine would enable
Special People Industries to meet future competitive or inflationary pressures to
a greater degree than the old machine.
If the increased efficiency of the new machine is due to labor or energy cost
savings, then additional increases in these costs in the future will favor the new
machinery even more.
The potential technological advances for new machines over the next several
years should be evaluated.
The space requirements for the new equipment should be reviewed and
compared with the present equipment to determine if more or less space is
required.
McGraw-Hill/Irwin
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16-22
2.
3.
$(70,000)
(200,000)
(29,840)
(39,600)
(100,000)
10,000
$(429,440)
$(28,000)
40,000
(12,000)
64,000
$64,000
$429,440
=6.710
$64,000
Find 6.710 in the 10-year row of Table IV of Appendix A. It falls in the 8 percent
column, so the internal rate of return on the runway project is 8 percent.
Conclusion: From a purely economic perspective, the longer runway should not be
approved, since its internal rate of return (8 percent) is lower than the hurdle rate (12
percent). Qualitative considerations, such as convenience for the countys residents,
should also be considered.
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$(28,000)
40,000
(12,000)
64,000
$64,000
5.650
$361,600
(70,000)
(200,000)
(29,840)
(39,600)
(100,000)
10,000
$(67,840)
2.
From a purely economic perspective, the board should not approve the runway,
since its net present value is negative. Qualitative considerations, such as the
convenience of the countys residents, should also be taken into consideration by
the board.
3.
(a)
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5.650
5.650
$429,440*
annual incremental benefit
$429,440
5.650
= $76,007 (rounded)
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$76,007
$20,000
28,000
12,000
60,000
$136,007
(40,000)
$96,007
Conclusion: In order for the longer runway to be economically justifiable, the $20,000
annual promotional campaign must result in an increase in tax revenue of $96,007 per year.
McGraw-Hill/Irwin
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Present
Value*
$6,139
9,689
6,804
4,774
3,350
2,353
1,834
1,609
1,414
1,238
544
$39,748
Forklift
Cash Flow:
Tax Savings
MACRS
(Depr.
.35)
Depreciation
$8,400
$120,000 20.00% = $24,000
13,440
120,000 32.00% = 38,400
120,000 19.20% = 23,040 8,064
120,000 11.52% = 13,824 4,838
120,000 11.52% = 13,824 4,838
120,000 5.76% = 6,912 2,419
*Cash flow discount factor in right-hand column (from Table III in Appendix A, r = .14).
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Present
Value*
$7,367
10,335
5,443
2,864
2,511
1,103
$29,623
Discount
Factor
.877
.769
.675
.592
.519
.456
.400
.351
.308
.270
.237
MicroTest Technology, Inc. should not purchase the new pump because the net
present value is a negative amount, $(70,547), as calculated in the following table:
20x2
$(608,000)
(12,000)
20x3
20x4
20x5
20x6
30,000
$82,658
75,000
21,600
$(590,000)
1.000
$(590,000)
Sum = $(70,547)
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** 20x3:
20x4, 20x5:
20x6:
2.
Factors other than the net present value that management should consider before
making the pump replacement decision include the following:
Availability of any necessary financing
Likelihood of further technological changes for the vacuum pumps
Reliability of the pumps
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Net-present-value analysis:
(a) Cost savings from manufacturing pressure fittings:
Per
Unit
Cost to purchase pressure fittings from outside supplier ..... $20.00
Incremental costs of manufacturing the pressure fittings*
Direct material ....................................................................... $4.50
Direct labor and variable overhead
($3.70 + $1.70 $1.60) ........................................................ 3.80
Total incremental costs ............................................................ $8.30
Cost savings from manufacturing pressure fittings .............. $11.70
Taxes (40%) ............................................................................... 4.68
After-tax cost savings of manufacturing pressure fittings .... $7.02
Total
$1,600,000
$ 360,000
304,000
$ 664,000
$ 936,000
374,400
$ 561,600
*No fixed overhead is included because it is not an incremental cost. The amount of
fixed overhead would not be affected by this decision, and the breakdown of the
fixed overhead between depreciation and cash expenditures is not relevant.
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Tax
Rate
40%
40%
40%
40%
Cash
Flow
$561,600
Discount
Factor
3.605
Present
Value
$2,024,568
Tax
Shield
$333,300
444,500
148,100
74,100
.893
.797
.712
.636
297,637
354,267
105,447
47,128
.567
.567
56,700
(22,680)
(2,500,000)
$363,067
Cash
Flow
40%
$100,000
(40,000)
________________________________________________________________________
Since the NPV is positive, management should replace the tools.
2.
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20x1
$(1,000,000)
20x2
20x3
20x4
20x5
$180,000
$180,000
$180,000
$180,000
Acquisition MACRS
Tax
Cost
Percentage Rate
$1,000,000
$1,000,000
$1,000,000
$1,000,000
33.33%
44.45%
14.81%
7.41%
.40
.40
.40
.40
................
................
................
................
133,320
177,800
59,240
29,640
60,000
(24,000)
$ (964,000)
1.000
$ (964,000)
$313,320
.893
$279,795*
$357,800
.797
$285,167*
Sum = $(95,368)
*Rounded.
McGraw-Hill/Irwin
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$239,240
.712
$170,339*
$209,640
.636
$133,331*
The machine replacements internal rate of return is between 6% and 8%. The
projects net present value is positive if a 6% discount rate is used, but it is negative
if an 8% discount rate is used.
Year
20x1 .................
20x2 .................
20x3 .................
20x4 .................
20x5 .................
Net present value
3.
Total After-Tax
Cash Flow
(from
requirement 1)
$(964,000)
313,320
357,800
239,240
209,640
6%
Present
Discount
Value
Factor
(using 6%)
1.000
$(964,000)
.943
295,461
.890
318,442
.840
200,962
.792
166,035
$16,900
8%
Discount
Factor
1.000
.926
.857
.794
.735
Present
Value
(using 8%)
$(964,000)
290,134
306,635
189,957
154,085
$(23,189)
The payback period on the machine replacement is between three and four years.
Year
20x2 ..........................................
20x3 ..........................................
20x4 ..........................................
Subtotal ...................................
20x5 ..........................................
Total .........................................
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Total After-Tax
Cash Inflow
(from requirement 1)
$ 313,320
357,800
239,240
$ 910,360< $964,000 = initial net cash outflow
209,640
$1,120,000> $964,000 = initial net cash outflow
With a salvage value of zero on the new machine, the machine replacements net
present value is $(95,368). Thus, the after-tax discounted cash flow from the salvage
of the new machine on December 31, 20x5 would have to exceed $95,368. Dividing by
the year 4, 12% discount factor, the after-tax cash flow would have to exceed
$149,950 ($95,368 .636, rounded). Let X denote the new machines salvage value on
December 31, 20x5. Then the gain on sale will also be X, since the new machine will
be fully depreciated. The tax on this gain will be .40X. Therefore, the following
equation must hold:
X .40X
$149,950
.60X
$149,950
$249,917 (rounded)
Thus, the salvage value of the new machine must exceed $249,917 in order to turn
the machine replacement into a positive net-present-value project.
Check:
Cash proceeds from sale of new machine .............................................
Gain on sale ......................................................................
$249,917
.40
Tax rate .............................................................................
Tax on gain .......................................................................
$99,967
After-tax cash flow from sale ..........................................
Discount factor (4 years, 12%) ........................................
Present value of cash flow from sale .............................
$249,917
(99,967)
$149,950
.636
$95,368
Adding the $95,368 to the negative net present value calculated in requirement (1) of
$(95,368), the new net present value is zero.
McGraw-Hill/Irwin
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16-34
$50,000
8.514
$425,700
400,000
$25,700
2.
Profitability index =
$35,800
6.145
$219,991
200,000
$19,991
$425,700
$400,000
= 1.06 (rounded)
$219,991
$200,000
= 1.10 (rounded)
The mall site ranks first on NPV, but the downtown site ranks first on the profitability
index.
4.
The two proposed restaurant projects have different lives, which makes it
particularly difficult to rank them. It is not clear what will happen in years 11 through
20 if the downtown site is chosen.
McGraw-Hill/Irwin
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Managerial Accounting, 8/e
Payback period =
initial investment
annual after - tax cash inflow
$400,000
$50,000
= 8 years
$200,000
$35,800
income taxes)
2.
initial investment
$50,000
$400,000
= 12.5%
$35 ,800
$200,000
= 17.9%
4.
Neither the payback period nor the accounting-rate-of-return method considers the
time value of money. Moreover, the payback method ignores cash flows beyond the
payback period.
On the positive side, both methods can provide a simple means of screening a
large number of investment proposals.
McGraw-Hill/Irwin
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16-36
4. Discounted-cash-flow methods take into account the time value of money, whereas
the payback and accounting-rate-of-return methods do not.
5. No, this would not be ethical. The theaters board is entitled to fair and objective
information about the project. (Refer to the ethical standards for managerial
accountants listed in Chapter 1 of the text, particularly the section entitled
Objectivity.)
McGraw-Hill/Irwin
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Managerial Accounting, 8/e
(1)
(2)
(3)
Year
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
After-Tax
Incremental
Cash Flow in
Real Dollars
(not including
depreciation shield)
$(188,000)*
42,000
42,000
42,000
42,000
42,000
42,000
42,000
Price
Index
1.0000
1
(1.20) = 1.2000
(1.20)2 = 1.4400
(1.20)3 = 1.7280
(1.20)4 = 2.0736
(1.20)5 = 2.4883
(1.20)6 = 2.9860
(1.20)7 = 3.5832
(4)
(5)
(7)
Total
After-Tax
After-Tax
Incremental
Cash Flow in
Cash Flow in
Nominal
Cash
Flow:
Nominal Dollars
Dollars
Tax Savings
(not including
MACRS
[Col. (4) + Col.
(depreciation .40)
depreciation shield)**
Depreciation
(6)]
$(188,000)
$(188,000)
50,400
$16,000
66,400
$200,000 20.00% = $40,000
60,480
25,600
86,080
200,000 32.00% = 64,000
72,576
15,360
87,936
200,000 19.20% = 38,400
87,091
9,216
96,307
200,000 11.52% = 23,040
104,509
9,216
113,725
200,000 11.52% = 23,040
125,412
4,608
130,020
200,000 5.76% = 11,520
150,494
150,494
$(200,000)
20,000
(8,000)
$(188,000)
McGraw-Hill/Irwin
16-38
(6)
3.
.10
.20
.02
.32
Year
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
Net present value
After-Tax
Cash Flow in
Nominal Dollars
$(188,000)
66,400
86,080
87,936
96,307
113,725
130,020
150,494
Discount
Factor*
1.000
.758
.574
.435
.329
.250
.189
.143
Present
Value
$(188,000)
50,331
49,410
38,252
31,685
28,431
24,574
21,521
$56,204
2.
McGraw-Hill/Irwin
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(2)
Year
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
After-Tax
Incremental
Cash Flow in
Real Dollars
(not including
depreciation shield)
$(188,000)*
42,000
42,000
42,000
42,000
42,000
42,000
42,000
(3)
(4)
Cash Flow:
MACRS
Tax Savings
Depreciation
[Depreciation .40]
$16,000
$200,000 20.00% = $40,000
25,600
200,000 32.00% = 64,000
15,360
200,000 19.20% = 38,400
9,216
200,000 11.52% = 23,040
9,216
200,000 11.52% = 23,040
4,608
200,000 5.76% = 11,520
(5)
Price
Index
1.0000
(1.20)1 = 1.2000
(1.20)2 = 1.4400
(1.20)3 = 1.7280
(1.20)4 = 2.0736
(1.20)5 = 2.4883
(1.20)6 = 2.9860
(1.20)7 = 3.5832
$(200,000)
20,000
(8,000)
$(188,000)
McGraw-Hill/Irwin
16-40
(6)
(7)
Total
After-Tax
Depreciation
Cash Flow in
Tax Shield in
Real
Real Dollars
Dollars
[Col. (4) Col. (5)] [Col. (2) + Col.(6)]
$(188,000)
$13,333
55,333
17,778
59,778
8,889
50,889
4,444
46,444
3,704
45,704
1,543
43,543
42,000
Year
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
Net present value
After-Tax
Cash Flow in
Real Dollars
$(188,000)
55,333
59,778
50,889
46,444
45,704
43,543
42,000
Discount
Factor*
1.000
.909
.826
.751
.683
.621
.564
.513
Present
Value
$(188,000)
50,298
49,377
38,218
31,721
28,382
24,558
21,546
$56,100
The difference between the NPVs computed in this and the preceding problem is
due to the cumulative rounding errors in the price indexes and discount factors.
McGraw-Hill/Irwin
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Managerial Accounting, 8/e
SOLUTIONS TO CASES
CASE 16-57 (60 MINUTES)
1.
The two main alternatives for the Board of Education are as follows:
(a) Use full-size buses on regular routes
(b) Use minibuses on regular routes
2.
If the board decides to use minibuses, then there are two options for the full-size
buses:
(a) Sell them
(b) Keep them in reserve
3.
$75,000*
*No discounting necessary, since the buses would be sold now (time 0).
(b) Annual savings on bus charter fees ($30,000 $5,000) ............
Annuity discount factor (Table IV: r = .12, n = 5) .......................
Present value of savings .............................................................
$25,000
3.605
$90,125
The full-size buses should be kept in reserve, since the NPV of that option is
greater.
McGraw-Hill/Irwin
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16-42
In the following incremental cost analysis, parentheses denote cash flows favoring the fullsize bus alternative.
Incremental annual cost of compensation for bus
drivers if minibuses are used
($18,000 3 more buses required) .................................................
Incremental annual maintenance and operating costs if
minibuses are used [($20,000 8) ($50,000 5)] .......................
Incremental annual cash flow (favors minibuses) ...........................
Annuity discount factor (Table IV in Appendix A: r = .12, n = 5) ....
Present value of incremental annual cash flows .............................
Cost of redesigning bus routes, retraining drivers, etc.
(time 0) ..............................................................................................
Acquisition cost of minibuses ($27,000 8) ....................................
Present value of savings on bus charter fees,
if minibuses are purchased [from requirement (3)] .......................
Net present value ...............................................................................
$(54,000)
90,000
$36,000
3.605
$129,780
(15,250)
(216,000)
90,125
$(11,345)
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$25,000
90,000
(54,000)
$61,000
(b) Second, calculate the initial cost if the minibuses are purchased:
Cost of redesigning bus routes, retraining drivers, etc. ...........
Acquisition cost of minibuses ($27,000 8) ..............................
Initial cost .....................................................................................
$(15,250)
(216,000)
$(231,250)
initial cost
annual cost savings
$231,250
$61,000
= 3.791 (rounded)
Find 3.791 in the five-year row of Table IV in Appendix A. It lies in the 10 percent
column, so the IRR on the minibus alternative is 10 percent.
6.
The cost of purchasing a full-size bus ($90,000) is irrelevant, because the board is
not contemplating the purchase of any full-size buses. The depreciation method
(straight-line) is also irrelevant, because depreciation is not a cash flow. The NPV
and IRR methods focus on cash flows.
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
minibuses be purchased. Second, he should not use the lure of a better job to try to
persuade his friend to recommend in favor of the minibuses. Third, when the
financial job becomes available at the dealership, there should be a search for the
best qualified individual. It is not clear that Reynolds is in a position to offer the job
to his friend.
McGraw-Hill/Irwin
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16-44
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Managerial Accounting, 8/e
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
New equipment ...... $(4,500,000)
Working capital ...... (1,000,000)
Disposition of
equipment:
Old forklift
100,000
trucks
New conveyor
belt system ......
Operating revenue
$700,000
$700,000
$700,000
$700,000
a
Operating savings
600,000
600,000
600,000
600,000
Tax effect b..............
160,000
(335,000)
(335,000)
(335,000)
(335,000)
Total cash flows $(5,240,000)
$965,000
$965,000
$965,000
$965,000
12% discount
factor*.................... 1.000 .893 .797 .712 .636
Present value ......... $(5,240,000) $861,745 $769,105 $687,080 $613,740
Net present value . . $ (235,280)
Year 5
Year 7
Year 8
$1,000,000
$700,000
$700,000
$700,000
(200,000)
600,000
600,000
(15,000) (295,000) (295,000)
$485,000 $1,005,000 $1,005,000
100,000
700,000
600,000
(335,000)
$2,065,000
McGraw-Hill/Irwin
16-46
Year 6
$500,000
300,000
(200,000)
$600,000
Year 5:
Same as above ..........................................................................................
Less: Equipment repairs ..........................................................................
Total .......................................................................................................
$600,000
(800,000)
$ (200,000)
Tax effects:
At time 0; disposal of forklifts:
Book value .................................................................................................
Less: Salvage value...................................................................................
Tax loss .....................................................................................................
Tax rate.......................................................................................................
Total cash inflow (tax savings) ............................................................
$500,000
(100,000)
$400,000
.40
$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 .............................................................. (562,500)
Increase in taxable income....................................................................... $837,500
Tax rate....................................................................................................... .40
Total cash outflow (increased taxes) .................................................. $(335,000)
*If the forklifts are sold, the loss of the depreciation deduction will increase taxes
just as the increased revenue and operating cost savings will increase taxes.
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$700,000
(200,000)
100,000
(562,500)
$37,500
.40
$ (15,000)
2.
Years 6 and 7:
Revenue......................................................................................................
Operating-cost savings.............................................................................
Depreciation on new equipment ..............................................................
Increase in taxable income.......................................................................
Tax rate.......................................................................................................
Total cash outflow (increased taxes) ..................................................
$700,000
600,000
(562,500)
$737,500
.40
$ (295,000)
Year 8:
Revenue......................................................................................................
Operating-cost savings.............................................................................
Depreciation on new equipment ..............................................................
Salvage value of new equipment .............................................................
Increase in taxable income.......................................................................
Tax rate.......................................................................................................
Total cash outflow (increased taxes) ..................................................
$700,000
600,000
(562,500)
100,000
$837,500
.40
$(335,000)
McGraw-Hill/Irwin
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16-48
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
resolution. One possible solution is to present a base case and sensitivity
analysis of the investment. Forrest should make it clear to Rolland that he has a
problem and is seeking guidance.
If Forrest cannot obtain a satisfactory resolution with Rolland, he should take the
situation up to the next layer of management and inform Rolland that he is doing
this. If this is not satisfactory, Forrest should progress to the next, and
subsequent, higher levels of management (e.g., the president or board of
directors) until the issue is resolved.
Since Rolland has instructed him not to discuss the situation with anyone else at
IDI, Forrest may want to have a confidential discussion with an objective advisor
to clarify relevant concepts and obtain an understanding of possible courses of
action. For example, he might want to talk to a close professional friend.
If Forrest cannot satisfactorily resolve the situation within the organization, he
may resign from the company and submit an informative memo to an appropriate
person in IDI (e.g., the president or board of directors).
McGraw-Hill/Irwin
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Research Proposal I has an NPV of $1,370 and Research Proposal II has an NPV of
$(14,375). The calculations are shown in the following table.
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
Research Proposal I:
Equipment
acquisition .............. $(40,000)
Contract fee ..............
$100,000
Operating costs ........
(150,000)
Total cash flow ......... $ (40,000) $ (50,000)
Discount factor*
1.000 .926
Present value ................ $ (40,000) $ (46,300)
Net present value
Research Proposal II:
Equipment
acquisition .............. $(70,000)
Contract fee ..............
$100,000
Operating costs ........
(75,000)
Total cash flow ......... $ (70,000) $25,000
Discount factor*
1.000 .926
Present value ................ $ (70,000) $23,150
Net present value
Year 2
Year 3
Year 4
Year 5
$100,000
(120,000)
$ (20,000)
.857
$ (17,140)
$100,000
(75,000)
$25,000
.794
$19,850
$100,000
(40,000)
$60,000
.735
$44,100
$100,000
(40,000)
$60,000
.681
$40,860
$100,000
(95,000)
$5,000
.735
$3,675
$100,000
(95,000)
$5,000
.681
$3,405
Sum = $1,370
$100,000
(75,000)
$25,000
.857
$21,425
$100,000
(95,000)
$5,000
.794
$3,970
Sum = $(14,375)
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
is placing her own perceived chances for a promotion ahead of the best interests of
the IES. Moreover, if Fenwar explains the reason why Proposal I is preferable to
Proposal II, in terms of discounted cash flows, it is likely that the board will
understand why Proposal I is a better alternative.
McGraw-Hill/Irwin
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