Chapter 9

Capital Budgeting Decisions

QUESTIONS
1. A capital expenditure decision is a decision involving the acquisition of a long-lived asset.
2. Time value of money must be considered because the value of money received in the future
from an investment is not equivalent to the value of money expended to acquire the
investment in the current period.
3. Two approaches that consider the time value of money are the net present value (NPV)
approach and the internal rate of return (IRR) approach.
4. With the net present value approach, investments are accepted if the net present value is
equal to or greater than zero. With the internal rate of return approach, investments are
accepted if the internal rate of return is equal to or greater than the required rate of return.
5. The cost of equity is the return demanded by shareholders for the risk they bear in
supplying capital to the firm.
6. Because depreciation reduces taxable income, it results in a tax savings equal to the tax rate
times the amount of depreciation.
7. The payback method does not consider the total stream of cash flows and it does not
consider the time value of money. The accounting rate of return method does not consider
the time value of money.
8. Managers may concentrate on short-run profitability rather than net present value if their
performance is evaluated and compensated based on current period profit.
9. With uneven cash flows, the internal rate of return is calculated using a trial and error
approach. Managers guess at the IRR and calculate the present value. If the present
value is greater than zero, the guess is increased. If the present value is negative, the guess
is decreased.
10. In many cases, the benefits of an investment are difficult to quantify (i.e., they are soft
benefits). However, ignoring them is equivalent to ignoring cash inflows and tends to
discourage investment.
Jiambalvo Managerial Accounting 9-2
EXERCISES
E1. Interest expense is not treated as a cash outflow because the charge for
interest is included in the cost of capital (i.e., the hurdle or discount rate).
E2. The NPV is positive and Pauline should make the investment.
Time Cash Flow PV Factors
0 (25,000,000) 1.0000 $(25,000,000)
1 5,500,000 0.8929 4,910,950
2 5,500,000 0.7972 4,384,600
3 5,500,000 0.7118 3,914,900
4 5,500,000 0.6355 3,495,250
5 5,500,000 0.5674 3,120,700
6 5,500,000 0.5066 2,786,300
7 5,500,000 0.4523 2,487,650
8 5,500,000 0.4039 2,221,450
NPV $ 2,321,800
Effect on End of Year
Income Investment ROI
1 2,375,000 21,875,000 0.109
2 2,375,000 18,750,000 0.127
3 2,375,000 15,625,000 0.152
4 2,375,000 12,500,000 0.190
5 2,375,000 9,375,000 0.253
6 2,375,000 6,250,000 0.380
7 2,375,000 3,125,000 0.760
8 2,375,000 0 division by zero
not defined
Although the project has a positive NPV, if Pauline is overly focused on
short-term performance, she may hesitate to make the investment, which
has a relatively low ROI in the first year. Note that ROI increases
dramatically as the book value of the investment decreases due to
depreciation.
Chapter 9 Capital Budgeting Decisions 9-3
E3. According to Mignogna,
You can often determine the cash benefit of increases in capacity,
production efficiency, and quality, as well as reductions in operating and
maintenance costs attributable to an investment in new technology.
However, seldom accounted for are the strategic benefits which result from
such investments. With the assistance of the accompanying decision-
making flow chart, lets look at a few.
First of all, is the investment required just to stay in game (for example,
required for regulatory compliance)? If so, and assuming the game is worth
being in, then you may not have any choice but to just do it!
Next, have you considered the importance of the investment to remain
competitive in your industry? Here, I am speaking of your ability to
acquire, or at least defend, market share. While discounted cash flow
analyses may include the benefits of reduced operating costs and so on,
they seldom consider the opportunity cost of the lost business which
results from your competitors ability to offer a higher quality at a reduced
cost. In other words, there may be a very real cost attached to not pursuing
an innovation.
There are several other strategic considerations that are not particularly
amenable to economic analyses. Will the investment add to or enhance
your firms core competencies? Will it provide the capability to penetrate
new markets with your product or service? Will expanded production
capacity provide access to increased sales and more rapid learning curve
progress which will ultimately lower costs? Are you in an industry where
the market perceives technological leadership as important? You can
probably think of others specific to your own situation. Such strategic
benefits are seldom considered in discounted cash flow analyses of new
technology. Remember, theres a big difference between running the
numbers and letting the numbers run you.
Jiambalvo Managerial Accounting 9-4
E4. Company Investment decision
Charles Schwab Should the company purchase additional servers and other
equipment to enhance services related to the online
business?
McDonalds Should the company purchase land, building, and
equipment for a new restaurant?
Wal-Mart Should the company remodel its superstore on the west
side of Chicago?
E5. Cash Present Value
Flow Factor Total
$100 .6209 $62.09
E6. Cash Present Value
Flow Factor Total
$100 3.7908 $379.08
E7. The numbers decrease from left to right in a given row because cash received
in the future is worth less the higher your required rate of return.
The numbers decrease from top to bottom in a given column because cash
received further in the future is less valuable today.
E8. Cash Present Value
Flow Factor Total
$200 3.7908 $ 758.16
500 .6209 310.45
$1,068.61
Chapter 9 Capital Budgeting Decisions 9-5
E9. Plan A
Total
$100,000.00
Plan B
Cash Present Value
Flow Factor Total
$ 10,000 6.7101 $ 67,101.00
100,000 .4632 46,320.00
$113,421.00
Plan C
Cash Present Value
Flow Factor Total
$20,000 6.7101 $134,202.00
Plan C should be selected as it has the highest present value.
E10. Cash Present Value
Flow Factor Total
($10,000) 1.0000 ($10,000.00)
4,000 3.0373 12,149.20
$ 2,149.20
The net present value is positive so the project should be undertaken.
Jiambalvo Managerial Accounting 9-6
E11. The investment should not be undertaken because it has a negative NPV.
Cash Present Value
Flow Factor Total
$6,000.00
(3,500.00)
950.00
(1,800.00)
1,650.00 5.2161 $8,606.56
(20,000.00) 1.0000 (20,000.00)
5,000.00 .2697 1,348.50
($ 10,044.94)
E12. Machine A should be purchased because it has the highest positive NPV.
Machine A
Cash Present Value
Flow Factor Total
$15,000.00 4.3553 $65,329.50
(50,000.00) 1.0000 (50,000.00)
$15,329.50
Machine B
Cash Present Value
Flow Factor Total
$20,000.00 4.3553 $87,106.00
(75,000.00) 1.0000 (75,000.00)
$12,106.00
Chapter 9 Capital Budgeting Decisions 9-7
E13. The investment should not be undertaken because the internal rate of return
of 12% is less than the required rate of 18%.
Initial outlay $79,100.00
Annuity amount 14,000.00
Outlay annuity amount 5.6500
Internal rate of return 12%
E14. a.
Initial outlay $79,137.00
Annuity amount 22,500.00
Outlay annuity amount 3.5172
Internal rate of return 13%
b. Nadine should make the investment because its return of 13% is greater
than the required return of 12%.
E15. Annual depreciation
$200,000 5 years $40,000.00
Annual tax savings
$40,000 .40 $16,000.00
Present value of $16,000 per year
for 5 years at 10%
$16,000 3.7908 $60,652.80
Jiambalvo Managerial Accounting 9-8
E16. Year Income (Loss)
1 ($100,000)
2 (50,000)
3 120,000
4 200,000
The $100,000 loss in year 1 will offset income in year 3 resulting in a tax
savings of $40,000 (i.e., $100,000 40% tax rate) in year 3.
With respect to the $50,000 loss in year 2, $20,000 of it can be used to offset
income in year 3 (resulting in a tax savings of $8,000 in year 3) and $30,000
of it can be used to offset income in year 4 (resulting in a tax savings of
$12,000 in year 4).
Cash Present Value
Flow Factor Total
$40,000.00 .6750 $27,000.00
8,000.00 .6750 5,400.00
12,000.00 .5921 7,105.20
$39,505.20
Chapter 9 Capital Budgeting Decisions 9-9
E17. The annual cash inflow is $5,700, calculated as follows:
Revenue $15,500
Less:
Cost other than depreciation 8,000
Depreciation 3,000
Income before taxes 4,500
Less taxes at 40% 1,800
Net income 2,700
Plus depreciation 3,000
Cash flow $5,700
The net present value is positive, so the smoker should be purchased.
Cash Present Value
Flow Factor Total
$5,700.00 4.5638 $26,013.66
(21,000.00) 1.0000 (21,000.00)
$ 5,013.66
E18. The payback period is 8.2 years as follows:
Cost $41,000.00
Cash inflows 5,000.00
Cost cash inflows 8.2 years
E19. The accounting rate of return is 30%:
Average income $30,000.00
Average investment ($200,000 2) 100,000.00
Accounting rate of return 30.00%
Jiambalvo Managerial Accounting 9-10
E20. As indicated, the NPV is close to zero ($145.00) at a rate of 14%. Thus, the
IRR is approximately 14%. Given that the required rate of return is only
13%, the e-commerce business should be developed.
PV at Cash PV
13% Flow Factor Total
$(1,000,000) 1.0000 $(1,000,000)
(500,000) 0.8850 (442,500)
200,000 0.7831 156,620
630,000 0.6931 436,653
750,000 0.6133 459,975
800,000 0.5428 434,240
$ 44,988
PV at Cash PV
14% Flow Factor Total
$(1,000,000) 1.0000 $(1,000,000)
(500,000) 0.8772 (438,600)
200,000 0.7695 153,900
630,000 0.6750 425,250
750,000 0.5921 444,075
800,000 0.5194 415,520
$ 145
PV at Cash PV
15% Flow Factor Total
$(1,000,000) 1.0000 $(1,000,000)
(500,000) 0.8696 (434,800)
200,000 0.7561 151,220
630,000 0.6575 414,225
750,000 0.5718 428,850
800,000 0.4972 397,760
$ (42,745)
Chapter 9 Capital Budgeting Decisions 9-11
E21. As indicated below, the NPV is zero with a required rate of return of 9
percent. Thus, the IRR is 9 percent.
PV at Cash PV
9% Flow Factor Total
$(2,200,100) 1.0000 $(2,200,100)
200,000 0.9174 183,480
400,000 0.8417 336,680
600,000 0.7722 463,320
800,000 0.7084 566,720
1,000,000 0.6499 649,900
$ 0
E22. The online business may help the company manage a potentially stodgy
image associated with its mall locations. Also, the online business may
actually generate a number of large sales for the brick and mortar locations.
Some customers will shop the Web site to make price and quality
comparisons, but they will be unwilling to make, for example, a $5,000
purchase of a diamond ring over the Internet. Thus, after seeing
merchandise on the Web site, they may visit one of Shermans mall stores to
make a purchase. These potential benefits would be difficult to quantify.
E23. The annual value of the soft benefit must be at least $88,492.44 for the
project to have a zero net present value. Given there is general agreement
that the annual soft benefit will be at least $90,000, Pritchard should invest
in the flexible manufacturing system.
A. Present value needed to yield a zero NPV $500,000.00
B. Present value of an annuity factor at 12% 5.6502
A B Required annual value of soft benefit $88,492.44
Jiambalvo Managerial Accounting 9-12
PROBLEMS
P1. The original contract was worth $6,790,700 in present value terms while the
new offer is worth $6,960,460. When the time value of money is taken into
account, it is obvious that the new offer is not much better than the old one.
Cash PV
Time Flow Factor Total
0 $3,000,000 1.0000 $3,000,000
1 1,000,000 0.9091 909,100
2 1,000,000 0.8264 826,400
3 1,000,000 0.7513 751,300
4 1,000,000 0.6830 683,000
5 1,000,000 0.6209 620,900
$6,790,700
Cash PV
Time Flow Factor Total
1 1,000,000 0.9091 909,100
2 1,100,000 0.8264 909,040
3 1,200,000 0.7513 901,560
4 1,300,000 0.6830 887,900
5 1,400,000 0.6209 869,260
5 4,000,000 0.6209 2,438,600
$6,960,460
Chapter 9 Capital Budgeting Decisions 9-13
P2. a. Present value of ship in Caribbean/Alaska itinerary at 10%
($68,095,769 7.6061) $517,943,229
Present value of ship in Caribbean/Eastern Canada itinerary at 10%
($53,490,300 7.6061) $406,852,571
Present value of ship in Caribbean/Alaska itinerary at 15%
($68,095,769 5.8474) $398,183,200
Present value of ship in Caribbean/Eastern Canada itinerary at 15%
($53,490,300 5.8474) $312,779,180
The cost of the ship is only $180,325,005. Therefore, the NPV will be positive
under all of the alternatives which provides strong evidence that the ship
should be purchased.
b. The NPV will be positive (suggesting that the ship should be purchased)
whether the required return is 10 percent or 15 percent.
c. The difference in present values is $111,090,658 ($517,943,229 -
$406,852,571). Thus, there is a high opportunity cost if the firm decides to
operate the ship in a Caribbean/Eastern Canada itinerary.
Jiambalvo Managerial Accounting 9-14
P3. Year 1 Year 2 Year 3 Year 4
Revenue $12,000,000 $6,000,000 $2,000,000 $500,000
Less amortization 12,000,000 4,000,000 0 0
Income before taxes 0 2,000,000 2,000,000 500,000
Less taxes 0 800,000 800,000 200,000
Net income 0 1,200,000 1,200,000 300,000
Add amortization 12,000,000 4,000,000 0 0
Cash flow $12,000,000 $5,200,000 $1,200,000 $300,000
Cash PV
Time Flow Factor Total
0 ($16,000,000) 1.0000 ($16,000,000)
1 12,000,000 .9091 10,909,200
2 5,200,000 .8264 4,297,280
3 1,200,000 .7513 901,560
4 300,000 .6830 204,900
$ 312,940
Since the NPV is positive, the company should produce the film.
Chapter 9 Capital Budgeting Decisions 9-15
P4. Cash flow per year:
Revenue $75,000
Less costs other
than depreciation 6,800
Depreciation 40,000
Income before taxes 28,200
Less taxes 11,280
Net income 16,920
Add depreciation 40,000
Cash flow $56,920
Annuity factor equals cost divided by annual cash flow:
($200,000 $56,920) 3.5137
This implies an internal rate of return of approximately 13% (factor is 3.5172)
Given the internal rate of return exceeds the required rate of 12%, the company
should invest in the remodel.
Jiambalvo Managerial Accounting 9-16
P5. a. The net present value is positive ($43,496.60). Thus the company should
invest in the paint and body shop.
Net income $ 51,000
Add depreciation 70,000
Annual cash flow $121,000
Cash Present Value
Flow Factor Total
$121,000 6.1446 $743,496.60
(700,000) 1.0000 (700,000.00)
$ 43,496.60
b. A present value of an annuity factor of 5.7851 implies an IRR of
approximately 12%.
Initial outlay $700,000
Annuity amount 121,000
Cost annuity 5.7851
Notethe annuity factor for 12% is 5.6502.
c. The payback period is approximately 5.8 years:
Initial outlay $700,000
Annual cash flow 121,000
Number of years to recover
initial investment 5.7851
d. The accounting rate of return is approximately 35%:
Average income $51,000
Average investment
($700,000 2) 350,000
Accounting rate of return 14.57%
Chapter 9 Capital Budgeting Decisions 9-17
P6. a. Present value of Machine A
Cash PV
Flow Factor Total
Labor saving $21,000
Power saving 1,300
Chemical saving 2,900
Add. Main. (1,000)
Add. Misc. (2,200)
Total 22,000 2.9137 $ 64,101.40
Cost (43,000) 1.0000 (43,000.00)
Installation (4,500) 1.0000 (4,500.00)
Residual value 3,200 .5921 1,894.72
NPV $18,496.12
b. Present value of Machine B
Cash PV
Flow Factor Total
Labor saving $29,000
Power saving 1,900
Chemical saving 3,200
Add. Main. (1,200)
Add. Misc. (2,300)
Total 30,600 2.9137 $ 89,159.22
Cost (73,000) 1.0000 (73,000.00)
Installation (5,000) 1.0000 (5,000.00)
Residual value 5,200 .5921 3,078.92
NPV $14,238.14
c. Both NPVs are greater than zero, so both are acceptable investments.
However, the company should purchase machine A since it has the highest
NPV.
Jiambalvo Managerial Accounting 9-18
P7. Crown should invest in the new limousine since the NPV is positive.
Net income $17,790
Add depreciation 12,000
Annual cash flow $29,790
Cash Present Value
Flow Factor Total
$29,790.00 3.4331 $102,272.05
20,000.00 .5194 10,388.00
(80,000.00) 1.0000 (80,000.00)
$ 32,660.05
P8. Island Ferry should not invest in the boat because the NPV is negative.
Revenue $293,000
Less:
Labor 84,000
Fuel 15,800
Maintenance 26,700
Miscellaneous 3,500
Depreciation 95,750
Income before taxes 67,250
Taxes 26,900
Net income 40,350
Depreciation 95,750
Annual cash flow $136,100
Cash Present Value
Flow Factor Total
$136,100.00 4.9676 $676,090.36
62,000.00 .4039 25,041.80
(828,000.00) 1.0000 (828,000.00)
($126,867.84)
Chapter 9 Capital Budgeting Decisions 9-19
P9. a. Revenue (35,000 $35) $1,225,000
Less:
Component cost 300,000
Direct labor 400,000
Depreciation 60,000
Miscellaneous 180,000
Advertising 130,000
Income before taxes 155,000
Taxes 62,000
Net income 93,000
Depreciation 60,000
Annual cash flow $ 153,000
Cash Present Value
Flow Factor Total
$153,000.00 3.4331 $525,264.30
10,000.00 .5194 5,194.00
(310,000.00) 1.0000 (310,000.00)
$220,458.30
b. The payback period is approximately 2 years:
Initial outlay $310,000
Annual cash flow 153,000
Number of years to recover
initial investment 2.026 years
c. The accounting rate of return is 60%:
Average income $93,000
Average investment
($310,000 2) $155,000
Accounting rate of return 60%
d. Given the positive NPV, company should invest in Autodial.
Jiambalvo Managerial Accounting 9-20
P10. Year 1 2 3 4 5 6 7
Income $45,000 48,750 52,688 56,822 61,163 65,721 70,507
Deprec. 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Cash flow $95,000 98,750 102,688 106,822 111,163 115,721 120,507
Year Cash flow Factor Total
1. $95,000 .8772 $ 83,334.00
2. 98,750 .7695 75,988.13
3. 102,688 .6750 69,314.40
4. 106,822 .5921 63,249.31
5. 111,163 .5194 57,738.06
6. 115,721 .4556 52,722.49
7. 120,507 .3996 48,154.60
7. 50,000 .3996 19,980.00
0. - 400,000 1.0000 - 400,000.00
NPV $ 70,480.99
Given the positive NPV, the company should invest in the new business.
Chapter 9 Capital Budgeting Decisions 9-21
P11. a. The cost of capital includes an allowance for expected inflation. Thus, in
periods where expected inflation is high, the cost of capital is high, and
firms demand a high return on their investments.
b. Note that cash flows increase by 4% per year (except for the cash flow
related to the depreciation tax shield).
Year 1 Year 2 Year 3 Year 4 Year 5
Cost savings $575,000 $598,000 $621,920 $646,797 $672,669
Taxes on
cost savings -201,250 -209,300 -217,672 -226,379 -235,434
Tax savings
related to depre. 140,000 140,000 140,000 140,000 140,000
Cash flow $513,750 $528,700 $544,248 $560,418 $577,235
Year Cash flow Factor Total
1 $513,750 .9091 $ 467,050
2 528,700 .8264 436,918
3 544,248 .7513 408,894
4 560,418 .6830 382,765
5 577,235 .6209 358,405
2,054,032
Less cost of machine 2,000,000
Net present value $ 54,032
Given the positive NPV, the company should invest in the manufacturing
equipment.
Jiambalvo Managerial Accounting 9-22
P12. Note that in problem 11, the NPV was only $54,032 using a 10% required
rate of return. This suggests that to determine the IRR, we should start with
a return larger than, but close to, 10 percent. Below, the cash flows are
brought to present value using an 11% rate of return. Since the sum of the
present values is approximately equal to the cost of the investment (a
difference of $1,620), the internal rate of return is approximately 11%.
Given that this is greater than the required return of 10%, the investment
should be undertaken.
Year Cash flow Factor Total
1. $513,750 .9009 $ 462,837
2. 528,700 .8116 429,093
3. 544,248 .7312 397,954
4. 560,418 .6587 369,147
5. 577,235 .5935 342,589
2,001,620
Less cost of machine 2,000,000
Net present value $ 1,620
Chapter 9 Capital Budgeting Decisions 9-23
P13. Most likely, a higher required rate of return should be used reflecting the
increased risk of the investment.
P14. a. Richards is evaluated and compensated based on ROI which has some
measure of income in the numerator (and a measure of investment in the
denominator). Thus, he will be highly focused on income. Some
investment opportunities facing his division may increase shareholder
wealth (as indicated by positive NPVs) but have a negative effect on
short-run accounting income. If that will cause Richards to miss a bonus
target, he may pass on these valuable investments.
b. I believe this will mitigate the problem. If Richards owns a great deal of
stock/and or options, he will have a strong incentive to work to increase
the firms stock price. And stock prices are likely to be positively
impacted when the firm takes on projects with positive NPVs.
Jiambalvo Managerial Accounting 9-24
P15. Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $63,000 $69,300 $76,230 $83,853 $92,238
Less:
Ingred. 25,200 27,720 30,492 33,541 36,895
Salary 25,000 27,000 29,000 31,000 33,000
Misc. 2,200 2,400 2,600 2,800 3,000
Depre. 8,000 8,000 8,000 8,000 8,000
60,400 65,120 70,092 75,341 80,895
Inc. before taxes 2,600 4,180 6,138 8,512 11,343
Taxes 1,040 1,672 2,455 3,405 4,537
Net income 1,560 2,508 3,683 5,107 6,806
Depre. 8,000 8,000 8,000 8,000 8,000
Cash flow $ 9,560 $10,508 $11,683 $13,107 $14,806
Year Cash flow Factor Total
1. $ 9,560 .8850 $ 8,460.60
2. 10,508 .7831 8,228.81
3. 11,683 .6931 8,097.49
4. 13,107 .6133 8,038.52
5. 14,806 .5428 8,036.70
5. 2,000 .5428 1,085.60
0. -40,000 1.0000 - 42,000.00
NPV ($ 52.28)
Using a rate of return of 13%, the NPV is approximately zero. Therefore, the
IRR is approximately 13%. Melrose should investment in the delivery
business given that the companys required rate of return is only 10%.