Chapter 2: Capital -Budge tin g Principles and Techniqu e s

Shapiro: Chapter 2: Capital-Budgeting Principles and Techniques

QUESTIONS
1. a. What is the relationship between accounting income and economic profit? Answer: Accounting income is calculated by taking revenues and subtracting all cash and noncash expenses (such as depreciation). Accounting income also often recognizes losses for tax purposes as ell! even though the economic loss may have taken place at another time. "conomic profit is the sum of the present values of all the cash flo s net of expenses generated by the firm#s actions. "conomic profit measures true increments to value! but is hard to measure. Accounting profit is correlated ith economic profit! but not perfectly so. Accounting profit can be measured much more easily. b. What is the relationship between accounting rate of return and economic rate of return? Answer: $he accounting rate of return is the ratio of after-tax profit to average book investment. "conomic rate of return is the ratio of after-tax economic profit to the market value of the investment. "conomic profit e%uals cash accruals to the asset combined ith changes in its market value. 2. In 1991, AT&T laid a transatlantic fiber optic cable costing $4 million that can handle ! , calls simultaneousl"# What is the pa"bac$ on this in%estment if AT&T uses &ust half its capacit" while netting one cent per minute on calls? Answer: &2'( )illion per year assuming the half capacity is for 2* hours a day! +,- days per year. $he annual payback is then -+.. 3. The satisfied owner of a new $1', car can be e(pected to bu" another ten cars from the same compan" o%er the ne(t ) "ears *an a%erage of one e%er" three "ears+ at an a%erage price of $1', *ignore the effects of inflation+# If the net profit margin on these cars is , percent, how much should an auto manufacturer be willing to spend to $eep its customers satisfied? Assume a 9 percent discount rate# Answer: At a 2( percent profit margin! the auto company ill earn an annuity of about &+!((( every three years for the next +( years. /iscounted at 0 percent! this annuity is orth &0!*(2! assuming that the first ne car is purchased three years from today. 1ence! an investment to keep customers satisfied ill have a positive 234 as long as the amount spent is less than &0!*(2. $hus! a car company should be illing to spend up to &0!*(2 in present value terms to keep its customers satisfied. A trick is available to calculate the present value of this annuity. 5ecognize that an annuity received every three years for +( years and discounted at 0 percent is e%uivalent to a '(-year annuity discounted at 20.-(20 percent since each cash flo term is discounted at ('.(0)+ 6 '.20-(20.

Chapter 2: Capital -Budge tin g Principles and Techniqu e s 4. -emonstrate that the following pro&ect has internal rates of return of and , percent# 7ear Cash flo ' 8&'!2(( 2 9:!2(( + 8'+!2(( percent, 1 * 9:!2(( percent,

Answer: $o demonstrate that an ;55 calculation is valid! compute the net present value at the ;55. A valid ;55 yields 234 6 (. 7ear ' 2 + * $otal Cash <lo -'!2(( 9:!2(( -'+!2(( 9:!2(( ( 34=(. -'!2(( 9:!2(( -'+!2(( 9:!2(( ( 34='((. -,(( 9'!>(( -'!,-( 9*-( ( 34=2((. -*((.(( 9>((.(( -*>>.>0 9>>.>0 (

5. -uring 199 , -ow .hemical generated the following returns on in%estment in its different business units/ ?usiness @nit 3lastics ChemicalsA3erformance 3roducts Consumer Bpecialties 1ydrocarbonsA"nergy Cther /o Chemical overall 5eturn on ;nvestment (.) ',., ',.: '2.: -.2 '., ''.>

0i%en these returns, which of the business units should -ow in%est additional capital in? What additional information would "ou need in order to ma$e that decision? Answer: $hese figures tell you hat /o earned in '00(. ;n order to decide on future investments! you need the follo ing informationD '. Ehether these returns are representative of those expected to be earned in the future in these different divisions. Ehat matters for investment decisionmaking are proFected future returns! not past returns. $o the extent that these returns vary idely from year to yearG hich they do in the chemical businessGhistorical return data for one year are meaningless. Cne reason these data may be misleading is that they are based on historical cost figures for investment. 7ou really ant to calculate returns on the replacement cost of assets. ;nflation ill cause asset values to be understated! hich ill

Chapter 2: Capital -Budge tin g Principles and Techniqu e s lead the return on investment to be overstated. 2. $he cost of capital for these divisions. "ach division is likely to have its o n risk and! hence! its o n cost of capital. A high return could Fust indicate a high degree of risk and! therefore! a high re%uired return. Ehat matters is the proFected return relative to the cost of capital. A high proFected return that is less than the risk-adFusted cost of capital ill yield a negative 234 investment. Conversely! a lo proFected return that exceeds the cost of capital ill yield a positive 234 investment. +. $he marginal return on investment in each division. "ven if the figures for! say! the plastics and chemicalAperformance products divisions exceed their cost of capital and are representative of those expected to be earned in the future! that does not automatically Fustify additional investment in those divisions. $hese figures tell us the average 5C;H for investment purposes you need the marginal 5C;. $hat is! hat matters for investment purposes is not the return on past investments but the return on future investments. As e have seen! many companies (e.g.! )onsanto! 3hilip )orris) have divisions that yield high returns on past investments but very lo returns on incremental investments. *. $he extent to hich these divisions sell to one another. /o Chemical is a vertically-integrated company. ;ts hydrocarbonsAenergy unit sells to its do nstream plastics unit! hich in turn sells to its consumer specialties unit. $hus! the profitability of these units depends critically on the prices at hich these internal transactions take place. <or example! the hydrocarbonsAenergy unit may be sho ing a lo 5C; simply because it sells petroleum to the plastics unit at a belo -market price. $hat is! the hydrocarbons unit may be very profitable but its profits are sho ing up in the plastics unit in the form of a lo price on ra materials. $his is a form of cross-subsidization. /isentangling the true profitability of the different units of a vertically-integrated company like /o turns out to be a very difficult task! but it is a necessary one for capital budgeting purposes. Ehat matters is ho profitable investments are from the standpoint of the overall company! not from the standpoint of the units undertaking those investments. -. $he returns associated ith specific assets and activities ithin each division. Ehat matters from an investment standpoint is not Fust ho ell each division can be expected to do in the future but ho ell specific proFects ithin each division can be expected to do. <or example! certain products ithin the profitable plastics division may be earning a *(. return hile others are only earning a 2. return. Bimilarly! certain 5I/ investments may be expected to yield a high return relative to their riskiness! hereas others have little chance of a significant payoff. At the same time! the lo -return hydrocarbonsAenergy division may have some very high-return proFects! hich are masked by a lot of value-destroying activities else here. Eithout detailed data on the returns associated ith each division#s various activities! customers! and products! one can#t say here investment dollars ould be best spent.

CHAPTER 2: PROBLEMS
1. A firm is considering in%esting in a pro&ect with the following cash flows/

Chapter 2: Capital -Budge tin g Principles and Techniqu e s 7ear 2et cash flo (&) ' 2!(( ( 2 +!(( ( + *!(( ( * +!-( ( +!(( ( , 2!(( ( : '!(( ( > '!(((

The pro&ect re1uires an initial in%estment of $1,,' , and the firm has a re1uired rate of return of 1 percent# .ompute the pa"bac$, discounted pa"bac$, and net present %alue, and determine whether the pro&ect should be accepted# Answer: 3ayback period 6 * years exactly. /iscounted payback period (r 6 '(.) 6 -.>* years. 2et 3resent 4alue (r 6 '(.) 6 &'',*.:(. $he proFect should be accepted. ;ntermediate CalculationsD
Cash Flows 1 2 3 4 5 6 7 8 Cash -12,500.00 2,000.00 3,000.00 4,000.00 3,500.00 3,000.00 2,000.00 1,000.00 1,000.00 PV 1,818.18 2,479.34 3,005.26 2,390.55 1,862.76 1,128.95 513.16 466.51 Cumulative 1,818.18 4,297.52 7,302.78 9,693.33 11,556.09 12,685.04 13,198.20 13,664.70

2. The 2ennco 3il .o# must decide whether it is financiall" feasible to open an oil well off the coast of .hina# The drilling and rigging cost for the well is $', , # The well is e(pected to "ield '!', barrels of oil a "ear at a net profit to 2ennco of $' a barrel for four "ears# The well will then be effecti%el" depleted but must be capped and secured at a cost of $4, , # 2ennco re1uires an annual rate of return of 14 percent on its in%estment pro&ects# 4hould 2ennco open the well? *Assume all of a "ear5s production occurs at the end of the "ear#+ Answer: 2et annual profit 6 ->-!((((&-.(() 6 &2.02-). 34(3roduction) 6 &2.02-) J 34;<Ar6'*.!n6* 6 2.02-) J 2.0'+: 6 &>.-2+). 34(Capping) 6 &*.((() J 34;<r6'*.!n6* 6 * J (.-02' 6 &2.+,>). 34(/rilling) 6 &-.(((). 234 6 34(3roduction) K 34(Capping) K 34(/rilling) 6 &>.-2+) K 2.+,>) K -.((() 6 &'.'-*). $he ell should be drilled! since the present value of the benefits exceeds the present value of the costs. $he term 234 (2et 3resent 4alue) refers precisely to the difference in present value bet een the benefits and the costs of a proFect.

Chapter 2: Capital -Budge tin g Principles and Techniqu e s 3. 6ac$ 7ic$laus, the golfing pro and real estate de%eloper, is thin$ing of ac1uiring an ! 8 acre propert" outside Atlanta that he intends to turn into an e(clusi%e communit" for 9 families# The cost of this propert" and the necessar" impro%ements is $) million# After setting aside a mandator" ,' percent of the propert" as green space, he figures he can sell the remaining lots for an a%erage of $9 , an acre# :" putting in a golf course on the , acres of green space, 7ic$laus belie%es he can instead sell the lots for an a%erage of $14 , an acre# The golf course, including clubhouse, has a pro&ected price tag of $9 million# In either e%ent, the pro&ect is e(pected to ta$e eight "ears to sell out at a rate of ;' lots per "ear# 6ac$ 7ic$laus faces a marginal ta( rate of 4 percent and can write off his land and de%elopment costs b" prorating these costs against each lot sold#
a. If his required return is 14 percent, should Jack Nicklaus go ahead with the initial project (i.e., a co unit! with no golf course"#

Answer: $he initial proFect! a community ith no golf course! re%uires an initial outlay of &+()! and reaps ,.:-) per year for > years in the absence of taxes and depreciation. $he present value of the decision at r 6 '*. and t 6 *(. can be determined from the follo ing formulaD b. 4hould he put in the golf course? Answer: Eith the golf course! the cost is &+,)! and pretax revenues are '(.-) per year. $he same calculations as above can be made ith the ne dataD 234 6 L+,!(((!((( 9 (' L (.*()('(!-((!((()(*.,+>0) 9 ((.*()(*!-((!((()(*.,+>0) 6 &'!-:*!:0:.-*. 2icklaus should build the golf course (exactly as e expected).

Chapter 2: Capital -Budge tin g Principles and Techniqu e s a.b. M An alternate display is illustrativeD 1ousing Eith Nolf Cnly Course &,!:-(!((( &'(!-((!((( +!:-(!((( *!-((!((( +!(((!((( ,!(((!((( '!2((!((( 2!*((!((( '!>((!((( +!,((!((( -!--(!((( >!'((!((( *.,+>>,* *.,+>>,* 2-!:*-!,0- +:!-:*!:0> +(!(((!((( +,!(((!((( L&*!2-*!+( &'!-:*!:0> -

Annual Bales Ann. Amortization Ann. 3retax 3rofit $ax ( = *(. ) Ann. Aftertax 3rofit Cash <lo 34;<A(r6'*.!n6>) 3resent 4alue Cost 2et 3resent 4alue

4. The .oin .oalition is tr"ing to get the <#4# go%ernment to replace the dollar bill with a gold8 colored dollar coin# 3ne argument is cost sa%ings# A dollar bill costs ,#9 cents to produce and lasts onl" about 1; months# A dollar coin, on the other hand, while costing 9 cents to produce, lasts for ) "ears# About 1#! billion dollar bills must be replaced each "ear# The start8up costs of switching to a dollar coin are li$el" to be 1uite high, howe%er# These costs ha%e not been estimated# a. What are the pro&ected a%erage annual cost sa%ings associated with switching from the dollar bill to a dollar coin? Answer: Bince each dollar bill in circulation lasts an average of '.*2 years (':A'2)! and '.> billion are replaced each year! this must mean that there are about 2.--, billion dollar bills in circulation. $he cost of replacing '.> billion dollar bills each year at a cost per bill of 2., cents is &*,.> million. Bince the dollar coin lasts +( years! only about >-.2 million (2.--, billionA+() coins must be replaced each year at an annual cost of &-.' million. $hus! the annual cost savings comes to approximately &*'.: million. b. Ta$ing into account onl" the cost sa%ings estimated in part a, how high can the start8up costs for this replacement pro&ect be and still "ield a positi%e 72= for the <#4# go%ernment? <se an ! percent discount rate# Answer: $he present value of the cost savings perpetuity estimated in part a! discounted at > percent! is &*'!:((!(((A.(>! or &-2'.2- million. 1ence! the start-up costs for replacing the dollar bill ith a dollar coin can be as high as &-2'.2- million in present value terms and this proFect ill still yield a positive net present value. 5. >ecent .ensus :ureau data show that the a%erage income of a college8educated person was $)4,)91 %ersus $,4,; 1 for those without college# At the same time, the annual tuition at public uni%ersities was $1,'99 %ersus $;,99) for pri%ate colleges# In the following 1uestions, assume there is no difference in income between public and pri%ate uni%ersit" graduates#

Chapter 2: Capital -Budge tin g Principles and Techniqu e s

a. $ased on these figures, what is the pa!%ack period for a college education, taking into account the four !ears of lost earnings while %eing in college# &o these calculations for %oth pu%lic and pri'ate colleges.

Answer: ?ased on the figures presented! the lost income during four years of college is * M &2*!:(' 6 &0>!>(* (if they don#t go to college they earn non-college incomes). $he cost of the four years of college at a public (private) university is &,!2,* (&+(!::2). Combining these figures yields a total (undiscounted) cost for a public university of &'(-!(,>. <or a private college! this cost comes to &'20!-:,. $he income advantage to a college education is &0!,0( (&+*!+0' - &2*!:('). <rom graduation! it takes '(-!(,>A0!,0( 6 '(.>* years to recover the cost of a public university education. $he e%uivalent figure for a private college is '20!-:,A0!,0( 6 '+.+: years. b. Assuming college graduation at age ,, and retirement at age 9', what is the internal rate of return on a college degree from a public uni%ersit"? a pri%ate uni%ersit"? Answer: <or a public university! the cash flo s are four years of annual net cash outflo s e%ual to &2,!2,: (&'!-,, 9 &2*!:(') and then *+ years of net cash inflo s e%ual to &0!,0( annually. Ehether all these cash flo s occur at the beginning or end of the year! the ;55 e%uals :.>0 percent (the timing of the cash flo s doesn#t matter because you are Fust multiplying the 234G hich must e%ual zeroGby a constant). <or a private university! the cash flo s are four years of annual net cash outflo s e%ual to &+2!+0* (&:!,0+ 9 &2*!:(') and then *+ years of net cash inflo s e%ual to &0!,0( annually. $he ;55 based on these numbers is ,.+2 percent. c. Assuming a ; percent discount rate, and the same wor$ing life as in part b, what is the net present %alue of a college degree from a public uni%ersit"? a pri%ate uni%ersit"? Answer: Assuming all cash flo s occur at the end of the year (here the timing does matter)! the 234 for a public university education is &'(!>:>. <or a private college! the 234 is -&0!>:,. 6. The ?un ?oods .orporation must decide on what new product lines to introduce ne(t "ear# After8ta( cash flows are listed below along with initial in%estments# The firm5s cost of capital is 1, percent and its target accounting rate of return is , percent# Assume straight8line depreciation and an asset life of fi%e "ears# The corporate ta( rate is )' percent# All pro&ects are independent#
Pro e!t % & C "#vestme#t '5,000 7,500 4,000 $ear 1 '800 1,250 600 2 '1,000 3,000 1,200 3 '350 2,500 1,200 4 '1,250 5,000 2,400 5 '3,000 5,000 3,000

a. .alculate the accounting rate of return on the pro&ect# Which pro&ects are acceptable according to this criterion? *7ote/ Assume net income is e1ual to after8ta( cash flow less depreciation#+

Chapter 2: Capital -Budge tin g Principles and Techniqu e s Answer: $otal A$ Cash <lo $otal /epreciation 2et ;ncome Avg 2et ;ncome 3roFect A ,*(( -((( '*(( 2>( 3roFect ? ',:-( :-(( 02-( '>-( 3roFect C >*(( *((( **(( >>(

Acctg 5ate of return (Average 2et ;ncome AAverage ?ook ;nv) A?; 6 $otal depreciationA2. ''.2. *0.+. **. 3roFects ? and C are acceptable based on a 2(. accounting rate of return. b. .alculate the pa"bac$ period# All pro&ects with a pa"bac$ of fewer than four "ears are acceptable# Which are acceptable according to this criterion? Answer: Assuming depreciation effects are included in the cash flo sD 3ayback A (years) 6 *.-+! 3ayback ? 6 +.'-! 3ayback C 6 +.*2. 3roFects ? and C are acceptable. Assuming depreciation has not been includedD 3ayback A (years) 6 *.(,! 3ayback ? 6 2.:+! 3ayback C 6 +.(,. 3roFects ? and C are acceptable. c. .alculate the pro&ects5 72=s# Which are acceptable according to this criterion? Answer: 234 6 34(After $ax Cash <lo s) L ;nitial ;nvestment Assuming depreciation has already been incorporatedD 234 A 6 L&:*2.:2! 234 ? 6 &+>('.>+! 234 C 6 &'-:*.('. 3roFects ? and C are acceptable. ;f depreciation has not been incorporated! and all riteoffs can be usedD 234 6 34(After $ax Cash <lo s) L ;nit ;nv 9 34(/epr $ax Bhield) 234 A 6 &-'>.0-! 234 ? 6 &-,0*.+*! 234 C 6 &2->+.+*. All proFects are acceptable.

Chapter 2: Capital -Budge tin g Principles and Techniqu e s d. .alculate the pro&ects5 I>>s# Which are acceptable according to this criterion? Answer: ;55 is the discount rate that makes 234 6 (. /epreciation includedD ;55 A 6 :.(.! ;55 ? 6 2:.(.! ;55 C 6 2+.+:. 3roFects ? and C are acceptable. (;55 O '2.) /epreciation not includedD ;55 A 6 '-.*+.! ;55 ? 6 +*.2+.! ;55 C 6 +(.-(. All proFects are acceptable. (;55 O '2.) e. Which pro&ects should be chosen? Answer: $he firm should follo the guidelines of the 234 rule. 7. Aptec, Inc#, is negotiating with the <#4# -epartment of @ousing and <rban -e%elopment *@<-+ to open a manufacturing plant in 4outh .entral A#A#, the scene of much of the rioting in April 199,# The proposed plant will cost $)#' million and is pro&ected to generate annual after8ta( profits of $'' , million o%er its estimated four8"ear life# -epreciation is straight8line o%er the four8"ear period and Aptec5s ta( rate is )' percent# @owe%er, gi%en the ris$s in%ol%ed, Aptec is loo$ing for a ta(8e(empt go%ernment subsid"# According to Aptec, the subsid" must be able to achie%e an" of the following four ob&ecti%es/ *1+ 2ro%ide a ,8"ear pa"bac$# *,+ 2ro%ide an accounting rate of return of )' percent# *)+ >aise the plant5s I>> to ,, percent# *4+ 2ro%ide an 72= of $1 million when cash flows are discounted at 1! percent# a. ?or each alternati%e suggested b" Aptec, de%elop a subsid" plan that minimiBes the costs to @<- of achie%ing Aptec5s ob&ecti%e# Cou can schedule the subsid" pa"ments at an" time o%er the four8 "ear period# Answer. 1ere are the alternatives ith their costsD 3ayback. $he annual cash flo s are the sum of after-tax profits plus depreciation of &+(,!2-( ((.+-M&+!-((!(((A*)! or &>-,!2-(. $he sum of the first t o years# cash flo s is &'!:'2!-((. $o bring the payback to t o years ill re%uire a subsidy of &'!:>:!-(( (&+!-((!((( - &'!:'2!-((). Bince the computation of payback is insensitive to hen the subsidy is paid! as long as it happens ithin the t o-year period! the present value of its cost can be minimized by providing it at the end of year 2. A55. $he accounting rate of return is +'.*+. (--(!(((A'!:-(!(((). ;n order to bring this up to +-.! it is necessary to bring average annual income up to &,'2!-(( ((.+-M'!:-(!((()! an average annual increase of ,2!-((. $he subsidy ill e%ual &2-(!((( (,2!-((M*). Bince the computation of A55 is insensitive to hen the subsidy is received! its present value can be minimized by providing it at the end of the four years. ;55. Eith a subsidy of &'!+,-!((( at time (! thereby lo ering its net investment to &2!'+-!(((!

Chapter 2: Capital -Budge tin g Principles and Techniqu e s Aptec ill get its ;55 up to 22.. Any delay ill result in a correspondingly higher re%uired subsidy (it ill accrue at the rate of 22. annually. <or example! if the subsidy ere to be provided at the end of the first year! it ould have to e%ual &'!,,-!+(( (&'!+,-!((( P '.22) to get Aptec#s ;55 up to 22.. 1ence! 1@/ ill minimize its costs of getting Aptec#s ;55 up to 22. by providing the subsidy immediately instead of aiting. 234. $he 234 of the proFect! discounted at '>.! is ('!'0,!,+-). 1ence! a subsidy e%ual to &'!'0,!,+- that is paid up front ill Fust provide a zero 234 hen discounted at '>.. $he subsidy ill rise at the rate of '>. annually if it is paid in a future year. b. Which of the four subsid" plans would "ou recommend to @<- if it uses a 1' percent discount rate? Answer. $he inning subsidy plan is that associated ith the A55 criterion. ?y paying &2-(!((( at the end of the four-year period! the present value of 1@/#s cost hen discounted at '-. ill be &'*2!0+>. 8. The ?ast ?ood chain is tr"ing to introduce its new @ot and 4pic" line of hamburgers# 3ne plan *4+ will include a big media campaign but less in8house production capabilit"# The other plan *A+ will concentrate on a more gradual roll8out of the pro&ect but will in%ol%e more in%estment in personnel training and so forth# The cost of capital is 1' percent# The cash flows *$ + are listed below# The initial in%estment for each is $4 , #
Pla# ( ) $ear 1 '250 100 2 '250 125 3 '150 200 4 '100 250 5 ' 50 125

a. .onstruct the 72= profiles for plans 4 and A# Which has the higher I>>? Answer: 3lan B has 234((((#s) 6 &'>:.(0 and ;55 6 +0.2>.! 3lan Q has 234((((#s) 6 &''>.(, and ;55 6 2-.,+.. 3lan B has the higher ;55. b. Which plan should ?ast ?ood choose using the 72= method? Answer: 3lan B also has the higher 234. c. Which plan *4 or A+ should ?ast ?ood choose? Wh"? Answer: @nder either criterion! <ast <ood should choose 3lan B.

Chapter 2: Capital -Budge tin g Principles and Techniqu e s d. At what cost of capital will the 72= and the I>> ran$ings conflict? Answer: <or this discount rate ('-.)! the 234 and ;55 do not conflict. $o find the discount rate here a conflict might occur! calculate the discount rate that makes the present value of the difference in cash flo s zero. ;n this case! the cash flo differences areD 7ear /iff ' &'( 2 &'2 + * L&-( L&'-( L&:-

;nspection reveals that the present value is zero hen the discount rate is zero. 234 and ;55 give identical recommendations for all positive discount rates in this example. 9# The >oost .orp# is considering a multiple8use doc$side comple( in a ma&or la$eside cit"# >oost uses accounting rate of return as its sole capital8budgeting criterion# The sales and e(penses *e(cluding depreciation+ are as follows *$ +/
$ear (ales *+,e#ses 1 '800 700 2 '5,000 3,500 3 '15,000 10,500 4 '25,000 17,500 5 '25,000 18,500

;nvestment in the proFect is &*( million today and the accelerated depreciation schedule applicable to this proFect is
$ear 1 152 223 214 215 21-

a. 4hould >oost accept the pro&ect using straight8line depreciation? Assume a target rate of return of 1' percent# Its ta( rate is 4 percent# Answer: Ee assume that 5oost Corp. has sufficient income to take full advantage of the tax shields afforded by depreciation. 7ear After $ax ;ncome BQ /epr ACC /epr BQ 2et Cash <lo ACC 2et Cash <l ' '>( >((( ,((( ++>( 2->( 2 0(( >((( >>(( *'(( **2( + 2:(( >((( >*(( -0(( ,(,( * *-(( >((( >*(( ::(( :>,( +0(( >((( >*(( :'(( :2,(

@nder straight-line average book value is the same! namely &2(!(((. Average after tax income is &2--,! and average annual depreciation is &>(((. $he accounting rate of return is (2--, L >((()A2(!((( 6 L2:.22.. $he proFect ould be reFected on this basis.

Chapter 2: Capital -Budge tin g Principles and Techniqu e s b. Would "our answer to *a+ change if >oost used accelerated depreciation? Answer: Accelerated depreciation results in the same numbers. c. With a cost of capital of 1 percent, would the pro&ect ha%e a positi%e 72= under straight8 line depreciation? <nder accelerated depreciation? Answer: Eith a cost of capital of '(.! the present value of the net cash flo s under straight-line depreciation is &2(.-,). @nder accelerated depreciation! the figure comes to &2(.*+). 2ote that Raccelerated depreciationS does not improve the present value in this problem. 2either method of depreciation Fustifies the &*() expenseH the net present value is negative regardless of the depreciation method chosen. 1 # 4weet -elights .o# is considering a mar$eting polic" for its brand of chocolates# Two mutuall" e(clusi%e ad%ertising strateg" changes are under consideration# The cash flows associated with each are as follows# The cost of capital for 4weet -elights is 1 percent#
(trate./ & $ear 0 -80 -40 1 040 020 2 040 020 3 040 020 4 020 5 020

a. Which of the two strategies would "ou prefer if neither decision can be repeated *i#e#, all future strategiesD decisions are e(pected to ha%e Bero 72=s+? Answer: ;f neither decision can be repeated! then one should choose the strategy ith the highest 234. <or plans A and ?! the 234#s are '0.*: and +-.>2! respectively. $herefore! plan ? ould be preferred. b. Which of the two strategies would "ou prefer if each strateg" can be repeated as often as possible? Answer: ;f each strategy can be repeated as often as possible! one should calculate the e%uivalent annual benefit derived from each of the proposals. "%uivalent Annual ?enefit M 34;<A 6 234. 3lan A ? Bummary '0.* +-.> of 234 : 2 5esultsD + 7ears 34;<A 2.*> +.:0 "A? :.>+ 0.*3lan ? ould be preferred in this instance as ell. CHAPTER 2: SPECIAL PROBLEM 1# 3wen .orporation plans to purchase a new machine that costs $1, , , has si( "ears of economic life, and generates a net annual cash flow of $4 , at the end of "ears 189 *all

Chapter 2: Capital -Budge tin g Principles and Techniqu e s cash flows ha%e ta$en into account depreciation and ta(es+# The firm also has the option to sell the machine at the end of "ears 189# The following are the net cash flows 3wen will recei%e from the sale of the machine at the end of each "ear#
*#1 o2 $ear 1 2 3 4 5 6 3et Cash Flow From (ale '100,000 85,000 75,000 60,000 30,000 0

The manager wants to determine an optimal replacement polic" for the machine# 3nce a polic" has been adopted, it will be implemented perpetuall" because it is assumed that the cost of the machine, the cash inflows, and the net cash flow from selling the old machines will be the same o%er time# -etermine the optimal polic", assuming a 1, percent discount rate# Answer: $he optimal replacement policy for the machine re%uires that the machine be sold on the date that maximizes the e%uivalent annual benefit derived from running the machine. <or example! if the machine is placed in service for + years only! the cash flo s areD 7ear Cash <lo ' &*(!((( 2 &*(!((( + &*(!(((9:-!((( 6 &''-!(((

Eith an initial investment of &'2(!(((! the 234 at r6'2. is given by &20!*-,.::. Cn an annual basis! this represents a &'2!2,*.+( benefit. $his fact follo s from the e%uationD NPV = Equivalent Annual Benefit * PVIFA

Chapter 2: Capital -Budge tin g Principles and Techniqu e s $he table belo summarizes the results for all possible service livesD $ermination ' 2 + * , 234 -!(((.(( '-!+,+.-2 20!*-,.:: +0!,2-.(, *'!2'+.> **!*-,.2 0 "A? -!,((.(( 0!(0(.-: '2!2,*.+ ( '+!(*-.0+M ''!*++.'2 '(!>'2.0'

$he maximal e%uivalent annual benefit is realized hen the machine is replaced every four years.