Answers to Questions s3

Chapter 10 Planning for Capital Investments

Answers to Questions

1. A capital investment is an investment in a long-term operational asset. Stocks and bonds are not operational assets but rather intangible legal agreements of ownership in another company or loans to another company. They are bought and sold in organized free markets, such as the New York Stock Exchange where there is a definable market price based on supply and demand. They are easily bought and sold for the market price. Capital investments are usually tangible assets that are not intended for resale but for use in production or other operations. They represent long-term investments in the company that are not easily sold or exchanged. The return on these investments is normally recovered by the additional revenues, or cost savings, generated by the asset.

2. This concept applies for the following reasons: 1) the smaller present amount can be invested to earn interest that increases its future worth, 2) there is risk associated with the receipt of a future amount so that it takes a greater amount in the future to equal the smaller amount today and 3) inflation depletes the buying power of a future amount so that it takes a greater amount in the future to equal the smaller amount today.

3. Yes, both statements mean that a dollar today has more value because it can be invested to earn interest, it has less risk associated with its receipt, and there is less risk of its decrease in buying power due to inflation. In the first statement, you make a comparison between two dollar amounts, a dollar amount in the present versus a dollar amount in the future. Given the choice between the same dollar amount today or in the future, the dollar amount today would have more value. Therefore, to make these two amounts equal in value the amount in the present would have to be a lesser amount – the present value of a future amount is less.

10-1 Chapter 10 Planning for Capital Investments

4. When a company invests in capital assets, it is giving up present dollars in exchange for future dollars. Since present dollars have more value, the company must be compensated for the exchange. This compensation is called the return on investment. It is usually expressed as a percentage. For example, if you invested $5,000 in a new computer and earned $500 of income in the first year of your investment you received a 10% return ($500/$5,000).

5. In order to obtain assets (capital) to make investments, businesses must pay owners dividends and lenders interest. The return paid to investors and creditors is the company’s cost of capital. The company must earn a return on its investments that equals or exceeds its cost of capital in order to stay in business. Accordingly, the cost of capital establishes the minimum acceptable rate of return on investments.

6. To determine the amount to invest today solve the following equation:

Investment x (0.10) + Investment = $500,000 Investment x (0.10 + 1) = $500,000 Investment = $500,000/1.10 = $454,545

$454,545 today has the same value as $500,000 a year from today assuming a 10% interest rate. You would be indifferent between the two alternatives.

7. Many times converting future values into their present value equivalents requires a considerable amount of mathematical manipulation, particularly if the future values extend beyond a year. Present value tables consist of conversion factors for different return rates and different time periods that can be used to easily transform future values into present values.

8. An annuity is a series of equal cash flows paid over equal time intervals at a constant rate of return. An example of an annuity receipt would be lottery winnings that were paid in $10,000 installments at the beginning of each year for 10 years.

9. Some programs offer an efficient means of converting future values into present value equivalents. The conversion power of the present value function available with software programs allows you to explore many possible present value scenarios by just changing variables within the functions (changing the present value assumptions to determine “what happens if”). The computer instantaneously does the calculations.

10. The mathematical formula based on the present value of an annuity table factor would be written as:

Annual payment x PV of an annuity factor @ 14% for 5 years = PV $100,000 x 3.433081 = $343,308 The Excel spreadsheet function would be written as:

PV(rate,nper,pmt)

11. The bank’s investment balance is declining each year. A part of the original investment is recovered with each payment made by Ms. Espinosa. Since the interest Ms. Espinosa pays is based on the investment balance, the amount of interest Ms. Espinosa is paying each year is declining. In order to maintain its 8% annual compounded interest, the bank will have to reinvest the entire payment (recovery of investment and return on investment) each year at 8% annual interest in order to earn 8% compounded interest on the original investment.

12. The higher net present value does not necessarily imply the better investment opportunity. Other factors such as the amount of the initial outlay and the availability of capital must also be considered. Additionally, the net present value approach does not address the issues of risk or uncertainty about the estimated future cash flows.

13. Projects that produce zero or positive net present values satisfy the desired rate of return criteria. In other words, the present value of cash inflows will be equal to or greater than the present value of cash outflows.

14. The net present value method does not provide a measure of the rate of return. It simply indicates whether or not a project meets the desired rate of return criterion. 15. The investment with the highest internal rate of return is not always the best investment even when risk is relatively equal. Firms have a limited supply of capital that is normally spread among investment alternatives. The selection of the mix of investments that produces the highest weighted average internal rate of return will maximize profitability. In other words, if there are $100,000 of available funds to invest, two investments that cost $50,000 each and earn 12% each may be better than one investment that costs $80,000 and earns 14% but leaves insufficient funds to invest further. 16. Pursuing the highest rate of return does not guarantee the maximum profit for companies. As long as an investment results in a return greater than the company's cost of capital, the investment will contribute additional profit to the company. If Spark Company insists on selecting only investment opportunities with the highest rate of return, it will miss many other opportunities to increase the company's profit. In other words, the company's profit would not be maximized under the company's current strategy. 17. The desired rate of return represents the level of return that management seeks to attain on all investments. The internal rate of return is the actual return from a particular investment. The internal rate of return must be equal to or greater than the desired rate of return in order to satisfy the rate of return criterion for acceptance. 18. Inflow items include incremental revenue, operating cost savings, salvage values, and working capital releases. Outflow items include the initial investment, increases in operating expenditures, and working capital commitments. 19. The strategy is not sound because it does not take into account the limitations of the payback method. For example, the technique does not take into consideration the total life of the asset. The asset that pays for itself more quickly may also have a much shorter useful life.

20. The payback method can be used when cash flows are unequal. A cumulative technique or an averaging technique can be employed. 21. The primary advantages of the unadjusted rate of return are simplicity and ease of understanding. The primary disadvantage is that the technique fails to take into account the time value of money.

22. Capital investments involve major commitments of resources that are recovered over extended future periods via increases in revenue or decreases in expenses. Once acquired, the assets are not easily sold. Instead, costs are normally recovered from the utilization of the assets. If the projected revenues or cost savings do not materialize, profitability suffers.

23. A postaudit consists of using the same analytical techniques used for evaluating a capital investment proposal in evaluating its success. A postaudit is conducted at the end of a capital investment project and based on actual cash inflows and outflows. The audit provides feedback that enables managers to improve the accuracy of future predictions and thereby maximize the quality of the company’s future capital investments.

Exercise 10-1A

Item Type of Cash Flow a. Incremental revenue Inflow b. Initial investment Outflow c. Salvage values Inflow d. Recovery of working capital Inflow e. Incremental expenses Outflow f. Working capital commitments Outflow g. Cost savings Inflow

Exercise 10-2A a. Present value Present value = Future value x Table Factor* Present value = $60,000 x 0.909091 Present value = $54,545 *Table 1, n = 1, r = 10% b. Investment + (0.10 x Investment) = $60,000 $54,545 + (0.10 x $54,545) = $60,000 $60,000 = $60,000

Exercise 10-3A a. Present value Present value = Future value x Table Factor* Present value = $500,000 x 0.567427 Present value = $283,714 *Table 1, n = 5, r = 12%

Ms. Pena should accept her employer’s offer of $300,000 because this amount is more than the present value of $500,000 to be received in the future ($283,714). b. The factors that cause the present value to be less than the amount of future value are (1) future interest, (2) less risk, and (3) future inflation.

Exercise 10-4A

a. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $10,000 x 0.925926(1) = $ 9,259.26 Present value = $10,000 x 0.857339(2) = 8,573.39 Present value = $10,000 x 0.793832(3) = 7,938.32 Total present value $25,770.97 (1)Table 1, n = 1, r = 8% (2)Table 1, n = 2, r = 8% (3)Table 1, n = 3, r = 8% b. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $10,000 x 2.577097(1) = $25,770.97 (1)Table 2, n = 3, r = 8% c. The present values are the same because the present value factor of Table 2 is simply the sum of the three values from Table 1. Exercise 10-5A a. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $20,000 x 2.913712* = $58,274.24 Present value = $30,000 x 0.592080** = 17,762.40 Total present value = 76,036.64 Cost of vans = (65,000.00) Net present value = $11,036.64 *Table 2, n = 4, r = 14% **Table 1, n = 4, r = 14% b. Since the net present value is positive, the investment opportunity can be expected to earn a rate of return that is greater than the cost of capital. The analysis suggests that the investment opportunity should be accepted.

Exercise 10-6A a. Year Cash Cash Net Cash Present Value Present Inflow  Outflow = Flows x Table Factor = Value 2009 $6,750  $4,500 = $2,250 x 0.925926 = $2,083.33 2010 9,750  7,800* = 1,950 x 0.857339 = 1,671.81 2011 10,500  6,300 = 4,200 x 0.793832 = 3,334.09 2012 11,250**  6,300 = 4,950 x 0.735030 = 3,638.40 Present value 10,727.63 Cost of equipment 10,500.00 Net present value $ 227.63 * $6,000 + $1,800 ** $10,500 + $750 b. The positive net present value indicates that the investment is earning a return that is above the desired rate of return and should be accepted.

Exercise 10-7A a. Alternative 1 Present value – Cash inflows $45,000 Present value – Cash outflows (42,000) Net present value $ 3,000

Alternative 2 Present value – Cash inflows $110,000 Present value – Cash outflows (106,500) Net present value $ 3,500

Exercise 10-7A (continued)

10-8 Chapter 10 Planning for Capital Investments b. Present Present value of value index cash inflows $45,000 for = ———————— = ———— = 1.07 Alternative 1 Present value of $42,000 cash outflows

Present Present value of value index cash inflows $110,000 for = ———————— = ————– = 1.03 Alternative 2 Present value of $106,500 cash outflows c. The higher present value index for Alternative 1 indicates that this investment opportunity will produce a higher internal rate of return than Alternative 2.

Exercise 10-8A a.

Present value table factor x $960,000 = $4,639,897.92 Present value table factor = $4,639,897.92  $960,000 Present value table factor = 4.833227

Looking at Table 2, at row 10, we find the factor 4.833227 under the rate of return column marked 16%. Accordingly, 16% represents the internal rate of return. b. Since the internal rate of return (16%) is greater than the hurdle rate (15%), the investment opportunity should be accepted.

Exercise 10-9A a. Determination of the annuity table values can be accomplished by dividing the cost of the investment by the annuity:

First investment: $7,001 ÷ $1,800 = 3.88965. Locating this value in Table 2 indicates that the investment is expected to earn an internal rate of return of 9%.

Second investment: $4,663 ÷ $1,875 = 2.486853. Locating this value in Table 2 indicates that the investment is expected to earn an internal rate of return of 10%. b. Since the second investment has a higher internal rate of return it should be accepted. c. Many other factors should be considered. Some of these are: (1) The life of the investments. The second investment has a three-year useful life. If the company is unable to reinvest funds at greater than 9% at the end of three years, its effective rate of return for the second investment could fall below the return generated by the first investment. (2) The size of the investment. If the company has $7001 (amount of the first investment opportunity) of funds available to invest and only invests $4,663 (amount of the second investment opportunity), then $2,338 ($7,001  $4,663) of uninvested funds will exist. If these funds are not invested at a rate greater than 9%, the overall return from the residual funds and the second investment could fall below 9%. (3) Confidence in the accuracy of projected cash flows. Uncertainty is just another word for risk. If the projections for one investment are less certain than the other, this risk factor should be considered in the final decision.

Exercise 10-10A

Revenues $630,000 Operating expenses (390,000) Depreciation expense (120,000) ($480,000 – $0)  4 Income before taxes 120,000 Tax expense (36,000) ($120,000 x 0.30) Net income 84,000 Add back depreciation 120,000 Net cash flows $204,000 (For years 2 to 4)

Because the cash expenditure for equipment will be $480,000, the first year's operations will result in a net cash outflow of $276,000 ($204,000 – $480,000).

Exercise 10-11A

Mr. Long does have a point. The company should evaluate the results of capital budget decisions through the practice of conducting postaudits. A postaudit should be conducted at the end of each capital investment project. The postaudit should repeat the analytical technique that was used to justify the original investment. For example, if an internal rate of return was used as the basis for approving an investment project, an internal rate of return computation should be used in the postaudit. The postaudit differs from the original computation in that the postaudit uses actual rather than estimated cash flows. This practice provides an opportunity to determine whether the expected results were actually achieved. The purpose of the postaudit should be continual quality improvement. No one should be chastised for making a mistake. However, everyone involved should be able to benefit from feedback regarding the quality of past projects. Individuals can and do learn from their mistakes. They will never learn from mistakes that they do not know occurred.

Exercise 10-12A a. Cash cost of investment  Annual cash inflow = Payback period Alternative 1 $9,000,000  $3,000,000 = 3 years Alternative 2 $18,000,000  $4,500,000 = 4 years Since the payback period for the first airplane is shorter, Alternative 1 should be accepted based on the payback method. b. The payback method does not consider the life of the investment. In this case, Alternative 1 provides the quickest payback but Alternative 2 continues to provide cash inflows for three years after Alternative 1 has expired. Also, the payback method does not consider the time value of money. Exercise 10-13A a.

Year Nature of Item Cash Flows 2010 Revenue $15,000 2011 Revenue 15,000 2012 Revenue 10,500 2012 Major overhaul (4,500) Total $36,000

The payback occurs at the end of 3 years. b. Average cash inflow is computed as follows: ($15,000 + $15,000 + $10,500  $4,500 + $9,000 + $7,200 + $4,800) ÷ 5 = $11,400 average per year

Payback period = $36,000 ÷ $11,400 = 3.2 years

Exercise 10-14A

a. Incremental increase in net income  Average cost of original investment $300  ($2,000  2) = 30% b. The unadjusted rate of return does not consider the time value of money.

Exercise 10-15A

a. $30,000 ÷ $15,000 = 2 years b. Depreciation expense = $30,000 ÷ 3 = $10,000 per year Incremental increase in net income = Revenue  Depreciation expense = $15,000  $10,000 = $5,000 Unadjusted rate of return = $5,000 ÷ ($30,000 ÷ 2) = 33.3%

Problem 10-16A

a. Alternative 1 Cash Inflows Table Value Present Value Annual cash inflows $210,000 x 2.7981811 = $587,618.01 Salvage value 75,000 x 0.5522912 = 41,421.83 Working capital recovery 30,000 x 0.5522912 = 16,568.73 Cash outflows Cost of vans (540,000.00) Working capital increase (30,000.00) Net present value $ 75,608.57

1Table 2, n= 4, r = 16% 2Table 1, n= 4, r = 16%

Problem 10-16A (continued)

Alternative 2 Cash Inflows Table Value Present Value Year 1 $120,000 x 0.8620691 = $103,448.28 Year 2 240,000 x 0.7431632 = 178,359.12 Year 3 300,000 x 0.6406583 = 192,197.40 Year 4 330,000 x 0.5522914 = 182,256.03 Salvage value 60,000 x 0.5522914 = 33,137.46 Cash outflows Cost of trucks (600,000.00) Training cost (12,000.00) Net present value $ 77,398.29 1Table 1, n = 1, r = 16% 3Table 1, n = 3, r = 16% 2Table 1, n = 2, r = 16% 4Table 1, n = 4, r = 16% b. Alternative 1: Present value of cash inflows $645,608.57 –––––––––––––––––––––––––––––––– = –––––––––––––– = 1.133 Present value of cash outflows $570,000

Alternative 2 Present value of cash inflows $689,398.29 –––––––––––––––––––––––––––––––– = –––––––––––– = 1.126 Present value of cash outflows $612,000 c. Alternative 1 will provide the higher rate of return, but alternative 2 results in a greater net present value. With Alternative 1 there is only $570,000 invested while there is $612,000 invested with Alternative 2. If additional funds can be invested at the rate of return provided by Alternative 1, then that alternative should be accepted. However, if the additional $42,000 of capital ($612,000 – $570,000) must sit idle, then Alternative 2 may be the better option if ADK Delivery actually has that much money. The information provided is insufficient to determine which the better alternative is.

Problem 10-17A a. Alternative 1 Alternative 2 Revenues $2,970 $4,140 Operating expenses (450) (1,215) Depreciation expense (1,350) (1,260) Income before taxes 1,170 1,665 Tax expense @ 20% (234) (333) Net income 936 1,332 Add back depreciation 1,350 1,260 Cash flow per year $2,286 $2,592

Alternative 1 Alternative 2

Payback Period Payback Period

$4,050 $5,040 = 1.77 years = 1.94 years $2,286 $2,592

Unadjusted rate of return: Unadjusted rate of return:

$936 $1,332 = 46.22% = 52.86% $2,025 $2,520 b. Because of its longer useful life and its higher unadjusted rate of return, the second alternative appears to be a better choice. However, if an investor desires the quickest recovery of funds, Alternative 1 does provide a quicker payback. Neither analytical technique considers the time value of money. There is no definitive right or wrong answer to this question. The answer depends on the investor's preference of a quick payback versus a higher rate of return.

Problem 10-18A a.

Project A Cash Inflows Table Value Present Value Annual cash inflows $94,641 x 3.312127* = $313,463.01 Cash outflows Cost of investment (300,000.00) Net present value $ 13,463.01

Project B Cash Inflows Table Value Present Value Annual cash inflows $39,507 x 3.312127* = $130,852.20 Cash outflows Cost of investment (120,000.00) Net present value $ 10,852.20 *Table 2, n = 4, r = 8%

Since Project A results in a greater net present value than Project B, Project A should be adopted based on the net present value method. b. Project A:

Present value table factor x $94,641 = $300,000 Present value table factor = $300,000  $94,641 Present value table factor = 3.169874

Looking at Table 2, at row 4, we find the factor 3.169865 under the rate of return column marked 10%. Accordingly, 10% is the approximate internal rate of return.

Project B:

Looking at Table 2, at row 4, we find the factor 3.037349 under the rate of return column marked 12%. Accordingly, 12% is the approximate internal rate of return.

Since Project B has a greater internal rate of return, it should be adopted according to the internal rate of return method. c. Each method has its own strengths and weaknesses. Project A generates a greater net present value, resulting from a greater initial investment. If the company has no other investment opportunities, Project A is clearly a better choice. However, If the company can invest in Project B for $120,000 and other projects with the remaining $180,000 for a similar rate of return, Project B would be preferable to Project A.

Problem 10-19A a. Project 1 Cash Inflows Table Value* Present Value Year 1 $44,500 x 0.925926 = $ 41,203.71 Year 2 47,000 x 0.857339 = 40,294.93 Year 3 63,000 x 0.793832 = 50,011.42 Year 4 81,000 x 0.735030 = 59,537.43 Cash outflows Cost of investment (150,000.00) Net present value $41,047.49 *Table 1, n = 1– 4, r = 8%

Project 2 Cash Inflows Table Value* Present Value Year 1 $82,000 x 0.925926 = $ 75,925.93 Year 2 87,000 x 0.857339 = 74,588.49 Year 3 14,000 x 0.793832 = 11,113.65 Year 4 12,000 x 0.735030 = 8,820.36 Cash outflows Cost of investment (150,000.00) Net present value $ 20,448.43 *Table 1, n = 1– 4, r = 8% Since Project 1 generates a greater net present value, it should be adopted based on the net present value method. b. Payback: Project 1: The sum of cash inflows from year 1 to year 3 = $44,500 + $47,000 + $63,000 = $154,500 > $150,000

Since $154,500 is very close to $150,000, the payback period of Project 1 is close to and less than 3 years.

Project 2: The sum of cash inflows for year 1 and year 2 = $82,000 + $87,000 = $169,000 > $150,000

Since $169,000 is greater than $150,000, the payback period of Project 2 is less than 2 years. Since Project 2 has a shorter payback period, it should be adopted based on the payback method. c. The net present value represents the net cash profit with the consideration of the time value of money for a particular investment opportunity. The payback period, on the other hand, measures how fast the original investment can be recovered without the consideration of the time value of money. In other words, it is a measurement of the risk of an investment rather than of profitability. Since the two methods measure two different characteristics of investments, neither method is better nor worse than the other one. If an investor is very concerned about the risk of an investment, he/she should probably use the payback method as the primary decision tool and the net present value method as the secondary tool. Under that circumstance, Project 2 should be adopted. If an investor pays the most attention to profitability and is less concerned about the market risk, he/she should use the net present value method as the primary decision tool and the payback method as the secondary tool. Under that circumstance, Project 1 should be adopted.

Problem 10-20A a.

Year 1 2 3 4 Revenues $72,000 $72,000 $72,000 $72,000 Depreciation (30,000) (30,000) (30,000) (30,000) Income before taxes 42,000 42,000 42,000 42,000 Income taxes @30% (12,600) (12,600) (12,600) (12,600) Net income 29,400 29,400 29,400 29,400 Add back depreciation 30,000 30,000 30,000 30,000 Cash flow $59,400 $59,400 $59,400 $59,400

Net Present Value Table Value Present Value Present value of cash inflows $59,400 x 3.0373491 = $180,419 Present value of salvage value 18,000 x 0.6355182 = 11,439 Present value of cash outflows (138,000) Net present value $ 53,858 1Table 2, n = 4, r = 12% 2Table 1, n = 4, r = 12%

Present value index $191,858 / $138,000 = 1.39 b.

Year 1 2 3 4 Revenues $ 72,000 $ 72,000 $ 72,000 $ 72,000 Depreciation* (69,000) (34,500) (16,500) (0) Income before taxes 3,000 37,500 55,500 72,000 Income taxes @ 30% (900) (11,250) (16,650) (21,600) Net income 2,100 26,250 38,850 50,400 Add back depreciation 69,000 34,500 16,500 0 Cash flow $ 71,100 $ 60,750 $ 55,350 $ 50,400

Problem 10-20A (b. continued)

*Double-declining-balance depreciation: Year 1: $138,000 x 2/4 = $69,000 Year 2: ($138,000 – $69,000) x 2/4 = $34,500 Year 3: ($138,000 – $69,000 – $34,500) x 2/4 = $17,250 However, the salvage value is $18,000, so the depreciation of Year 3 is adjusted to $16,500. Beginning balance of Year 4 = $138,000 – $69,000 – $34,500 – $16,500 = $18,000 = the salvage value

Present Net Present Value Table Value* Value Present value of cash inflows Year 1 $71,100 x 0.892857 = $ 63,482 Year 2 60,750 x 0.797194 = 48,430 Year 3 55,350 x 0.711780 = 39,397 Year 4 50,400 x 0.635518 = 32,030 Present value of salvage value 18,000 x 0.635518 = 11,439 Present value of cash outflows (138,000) Net present value $ 56,778 *Table 1, n = 1 – 4, r = 12%

Present value index $194,778 / $138,000 = 1.41 c. The net present value and the present value index are higher under double-declining-balance depreciation because the accelerated depreciation delays the cash payment of taxes.

d. Payback $138,000 / $59,400 = 2.32 years Unadjusted rate of return $29,400 / $69,000 = 43% Alternative giving consideration to salvage value: Unadjusted rate of return $29,400 / $60,000 = 49%

Problem 10-20A (continued) e. Average annual cash flow: (1/4) ($71,100 + $60,750 + $55,350 + $50,400) = $59,400

Average annual income: (1/4) ($2,100 + $26,250 + $38,850 + $50,400) = $29,400

Payback $138,000 / $59,400 = 2.32 years Unadjusted rate of return $29,400 / $69,000 = 43%

Alternative giving consideration to salvage value: Unadjusted rate of return $29,400 / $60,000 = 49% f. There is no difference in the payback period or unadjusted rate of return when straight-line versus double-declining-balance depreciation is used because these analytical techniques do not give consideration to the time value of money.

Problem 10-21A a. Cash Inflows Table Value* Present Value Year 1 $31,500 x 0.892857 = $ 28,125.00 Year 2 36,000 x 0.797194 = 28,698.98 Year 3 45,000 x 0.711780 = 32,030.10 Year 4 69,000 x 0.635518 = 43,850.74 Cash outflows Cost of investment (150,000.00) Net present value $ (17,295.18) *Table 1, n = 1 – 4, r = 12%

Since the net present value of the project is negative, Mr. Alma should not approve the project. b. & c.

The cash flow should increase by $9,000 per year ($30,000 x 30%) due to the tax deduction on depreciation.

The revised cash flow forecast and the net present value computation should be as follows:

Cash Inflows Table Value Present Value Year 1 $ 40,500 x 0.892857 = $ 36,160.71 Year 2 45,000 x 0.797194 = 35,873.73 Year 3 54,000 x 0.711780 = 38,436.12 Year 4 78,000 x 0.635518 = 49,570.04 Cash outflows Cost of investment (150,000.00) Net present value $ 10,040.60

Since the net present value with the revised cash flow is positive, Mr. Alma should approve the project.

Problem 10-22A a. Unadjusted Rate of Return:

Average increase in net income  Average net cost of original investment $21,000  $150,000 = 14% Since the rate of return under this definition is more than the required minimum rate of 10%, the company should invest in the equipment. b. Internal Rate of Return: Present value table factor x $83,100 = $300,000 Present value table factor = $300,000  $83,100 Present value table factor = 3.610108 Looking at Table 2, at row 5, we find the factor 3.604776 under the rate of return column marked 12%. Accordingly, 12% approximates the internal rate of return of this project.

Since the internal rate of return is greater than the minimum requirement of 10%, the company should invest in this project. c. The internal rate of return is the better method for this capital investment decision because the method takes into account the time value of money while the unadjusted rate of return does not.

Problem 10-23A a. Cash Inflows Table Value* Present Value Year 1 $3,300,000 x 0.925926 = $ 3,055,556 Year 2 4,920,000 x 0.857339 = 4,218,108 Year 3 4,560,000 x 0.793832 = 3,619,874 Year 4 4,980,000 x 0.735030 = 3,660,449 Year 5 4,200,000 x 0.680583 = 2,858,449 Cash outflows Cost of investment (15,000,000) Net present value $ 2,412,436 *Table 1, n = 1 – 5, r = 8% b. Cash Flows Table Value Present Value Year 1 $2,700,000 x 0.925926 = $ 2,500,000 Year 2 3,060,000 x 0.857339 = 2,623,457 Year 3 4,920,000 x 0.793832 = 3,905,653 Year 4 3,900,000 x 0.735030 = 2,866,617 Year 5 3,600,000 x 0.680583 = 2,450,099 Cash outflows Cost of investment (15,000,000) Net present value $ (654,174) c. The postaudit reveals that the original cash flow estimates were inaccurate. Had the decision makers known the real cash flows in advance, they would have rejected the investment opportunity. This result may also cause forecasters of cash flows to be more conservative in their future forecasts.

Exercise 10-1B

Potential Cash Inflows: Incremental revenue Salvage values Cost savings Recovery of working capital

Potential Cash Outflows: Initial cost of investment Incremental expenses Cost of overhaul or additional investments Working capital commitments

The above is a partial list of possible cash flows. There may be others.

Exercise 10-2B

a. Present Value Present Value = Future Value x Table Factor(1) = Present Value Present value = $75,000 x 0.925926 = $69,444.45 (1)Table 1, n = 1, r = 8%

b. Investment + (0.08 x Investment) = $75,000 Investment = $75,000/1.08 Investment = $69,444

Exercise 10-3B

a. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $800,000 x 0.751315 = $ 601,052

(1)Table 1, n = 3, r = 10%

b. Horace’s friend is obviously not much of a friend. He is offering Horace $400,000 for an asset that is worth $601,052. This so-called friend is seeking to profit financially from Horace’s ignorance about the present value of future cash flows.

Exercise 10-4B

a. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $3,000 0.909091(1) = $ 2,727.27 Present value = $3,000 0.826446(2) = 2,479.34 Total present value $ 5,206.61 (1)Table 1, n = 1, r = 10% (2)Table 1, n = 2, r = 10%

b. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $3,000 x 1.735537(1) = $5,206.61 (1)Table 2, n = 2, r = 10%

c. The total present values are the same because the present value factor from Table 2 is the sum of the two values from Table 1.

Exercise 10-5B a. Present Value Present Value = Future Value x Table Factor = Present Value Present value = $1,200 x 2.245890(1) = $2,695.07 Present value = $750 x 0.640658(2) = 480.49 Total present value = 3,175.56 Cost of popcorn machine = (3,750.00) Net present value = $ (574.44) (1)Table 2, n = 3, r = 16% (2)Table 1, n = 3, r = 16%

b. Since the net present value is negative, the investment opportunity is expected to earn a rate of return that is less than the desired rate of return. The analysis suggests that the investment opportunity should be rejected.

Exercise 10-6B a. Year Cash Cash Net Cash Present Value Present Inflow  Outflow = Flow x Table Factor(3) = Value 2010 $ 5,100  $2,400 = $2,700 x 0.892857 = $ 2,410.71 2011 5,700  3,180(1) = 2,520 x 0.797194 = 2,008.93 2012 6,300  2,880 = 3,420 x 0.711780 = 2,434.29 2013 8,700(2)  3,000 = 5,700 x 0.635518 = 3,622.45 Present value 10,476.38 Cost of van 9,900.00 Net present value $ 576.38 (1)$2,700 + $480 (2) $6,900 + $1,800 (3)Table 1, n = Periods 1, 2, 3, 4, r = 12%

b. The positive net present value indicates the investment would earn a return above the desired rate of return. Mr. Custer should start the delivery business.

Exercise 10-7B a. Alternative 1 Present value – Cash inflows $266,000 Present value – Cash outflows (254,000) Net present value $ 12,000

Alternative 2 Present value – Cash inflows $460,000 Present value – Cash outflows (446,000) Net present value $ 14,000 b. Present Present value of value index cash inflows $266,000 for = ———————— = ———— = 1.05 Alternative 1 Present value of $254,000 cash outflows

Present Present value of value index cash inflows $460,000 for = ———————— = ————– = 1.03 Alternative 2 Present value of $446,000 cash outflows c. The higher present value index for Alternative 1 indicates that this investment opportunity will produce a higher internal rate of return than Alternative 2, even though it produces a lower net present value.

Exercise 10-8B a.

Present value table factor x $450,000 = $1,345,775 Present value table factor = $1,345,775.40  $450,000 Present value table factor = 2.990612

In row 5 of Table 2, the factor 2.990612 appears in the 20% rate of return column. Therefore, the internal rate of return is 20%. b. Since the internal rate of return (20%) is more than the cost of capital (18%), Mann should accept the investment opportunity.

Exercise 10-9B a. Determine the annuity table values by dividing the cost of the investment by the annuity amount:

First opportunity: $74,756 ÷ $10,500 = 7.119630. Based on where this value appears in Table 2, Row 17, this investment is expected to earn a 12% internal rate of return.

Second opportunity: $68,455 ÷ $9,000 = 7.60608. Based on where this value appears in Table 2, Row 15, this investment is expected to earn a 10% internal rate of return. b. Because it has a higher internal rate of return, Ms. Shea should select the first investment opportunity. c. Ms. Shea could also use the net present value method or the present value index to compare the two investment opportunities.

Exercise 10-10B

Revenues $14,000 Operating expenses (2,400) Depreciation expense (8,000) ($28,000 – $4,000)  3 Income before taxes 3,600 Income tax expense (1,080) ($3,600 x 0.30) Net income 2,520 Add back depreciation 8,000 Net cash flows $10,520

Exercise 10-11B

A postaudit provides an opportunity to determine whether the results expected from an investment opportunity were actually achieved. The postaudit involves substituting the actual investment results in place of the estimated results into the original evaluation technique. Ms. Petifer appears to be unduly conservative. Her policy of intentionally underestimating projected cash flows may have resulted in rejecting attractive investment opportunities that would have contributed to the company’s profitability. The primary objective in projecting cash flows is accuracy, not conservatism.

Exercise 10-12B a.

Cash cost of investment  Annual cash inflow = Payback period Alternative 1 $150,000  $60,000 = 2.5 years Alternative 2 $189,000  $67,500 = 2.8 years

Since the payback period for the first machine is shorter, that is the one Keller should buy based on the payback method. b. The payback method does not consider the life of the investment. In this case, Alternative 1 provides the quickest payback but Alternative 2 continues to provide cash inflows for two years after Alternative 1 has expired. Also, the payback method ignores the time value of money. Exercise 10-13B a.

Year Nature of Item Cash Flows 2010 Revenue $10,000 2011 Revenue 7,500 Total $17,500

The payback occurs at the end of 2 years. b. Compute average cash flow as follows:

[$10,000 + $7,500 + ($6,875 – $2,500) + $3,750 + ($2,500 + $2,000)] ÷ 5 = $6,025 average per year

Payback period = $17,500 ÷ $6,025 = 2.9 years

Exercise 10-14B a. $5,025  ($30,000/2) = 33.50% b. The unadjusted rate of return does not consider the time value of money. Exercise 10-15B a. $27,000 ÷ $9,000 = 3 years b. Depreciation expense = $27,000 ÷ 4 = $6,750 per year Incremental increase in annual net income = Revenue  Depreciation expense = $9,000  $6,750 = $2,250 Unadjusted rate of return = $2,250 ÷ ($27,000 ÷ 2) = 16.67% c. No, the company should not purchase the additional boat. The unadjusted rate of return is below the company’s desired rate of return, which is 30%.

Problem 10-16B a. Alternative 1 Cash Inflows Table Value* Present Value Year 1 $ 24,000 x 0.892857 = $ 21,428.57 Year 2 48,000 x 0.797194 = 38,265.31 Year 3 76,000 x 0.711780 = 54,095.28 Year 4 96,000 x 0.635518 = 61,009.73 Year 5 120,000 x 0.567427 = 68,091.24 Salvage value 80,000 x 0.567427 = 45,394.16 Working capital recovery 60,000 x 0.567427 = 34,045.62 Cash outflows Cost of investment (240,000.00) Working capital increase (60,000.00) Net present value $ 22,329.91 *Table 1, n = 1 – 5, r = 12%

Exercise 10-16B (continued)

Alternative 2 Cash Inflows Table Value Present Value Annual cash inflows $60,000 x 3.6047761 = $216,286.56 Salvage value 40,000 x 0.5674272 = 22,697.08 Cash outflows Cost of investment (200,000.00) Cost of training (20,000.00) Net present value $ 18,983.64 1Table 2, n = 5, r = 12% 2Table 1, n = 5, r = 12% b. Alternative 1 Present value of cash inflows $322,329.91 ––––––––––––––––––––––––––––––– = ––––––––––––– = 1.074 Present value of cash outflows $300,000.00 Alternative 2 Present value of cash inflows $238,983.64 –––––––––––––––––––––––––––––––– = ––––––––––––– = 1.086 Present value of cash outflows $220,000.00 c. Alternative 1 results in a greater net present value, but Alternative 2 will provide the higher rate of return. With Alternative 2 there is only $220,000 invested while there is $300,000 invested with Alternative 1. If additional funds can be invested at the rate of return provided by Alternative 2, then that alternative should be accepted. However, if the additional $80,000 of capital ($300,000 – $220,000) must sit idle, then Alternative 1 may be the better option. The information provided is insufficient to determine which is the better alternative.

Problem 10-17B a. Alternative 1 Alternative 2 Cash revenue $75,000 $127,500 Cash expenses (42,000) (70,500) Amortization expense (15,000) - Depreciation expense - (27,000) Income before taxes 18,000 30,000 Income tax expense @ 20% (3,600) (6,000) Net income 14,400 24,000 Add back amortization 15,000 - Add back depreciation - 27,000 Cash flow per year $29,400 $51,000

Alternative 1 Alternative 2

Payback Payback $60,000 $108,000 –––––––––– = 2.04 years –––––––––– = 2.12 years $29,400 $51,000 Unadjusted rate of return Unadjusted rate of return

$14,400 $24,000 ––––––––––– = 48% –––––––––– = 44% $30,000 $54,000 b. Because of its shorter payback period and its higher unadjusted rate of return, the first alternative appears to be a better choice. However, neither analytical technique considers the time value of money.

Problem 10-18B a.

Project 1 Cash Inflows Table Value Present Value Annual cash inflows $ 14,400 x 3.387211 = $48,775.84 Cash outflows Cost of investment (44,000.00) Net present value $ 4,775.84

Project 2 Cash Inflows Table Value Present Value Annual cash inflows $7,000 x 3.387211 = $23,710.48 Cash outflows Cost of investment (20,000.00) Net present value $ 3,710.48

Project 1 should be adopted based on the net present value method because Project 1 results in a greater net present value than Project 2. b. Project 1: Present value table factor x $14,400 = $44,000 Present value table factor = $44,000  $14,400 Present value table factor = 3.055556 Looking at Table 2, at row 4, we find the factor 3.037349 under the rate of return column marked 12%, which is close to, and less than, the factor 3.055556. Accordingly, the approximate internal rate of return of Project 1 is close to, and less than, 12%.

Problem 10-18B (continued)

Project 2:

Looking at Table 2, at row 4, 2.857143 would be between factor 2.798181 under the rate of return column marked 16% and 2.913712 in the 14% column. Accordingly, the approximate internal rate of return of Project 2 is more than 14% and less than 16%, or about 15%.

Since Project 2 has a greater internal rate of return, it should be adopted according to the internal rate of return method. c. Each method has its own strengths and weaknesses. Project 1 generates a greater net present value, resulting from a greater initial investment. If the company has no other investment opportunities, Project 1 is clearly a better choice. However, if Mr. Maynard can invest in Project 2 for $20,000 and other projects with the remaining $24,000 for a similar rate of return, Project 2 would be preferable to Project 1.

Problem 10-19B a. Project A Cash Inflows Table Value* Present Value Year 1 $273,600 x 0.909091 = $248,727.30 Year 2 156,000 x 0.826446 = 128,925.58 Year 3 88,800 x 0.751315 = 66,716.77 Year 4 100,800 x 0.683013 = 68,847.71 Cash outflows Cost of investment (480,000.00) Net present value $33,217.36 *Table 1, n = 1 – 4, r = 10%

Project B Cash Inflows Table Value Present Value Year 1 $ 88,400 x 0.909091 = $ 80,383.64 Year 2 80,400 x 0.826446 = 66,446.26 Year 3 177,600 x 0.751315 = 133,433.54 Year 4 405,600 x 0.683013 = 277,030.07 Cash outflows Cost of investment (480,000.00) Net present value $ 77,293.51

Since Project B generates a greater net present value, it should be adopted based on the net present value method. b. Payback Period:

Project A:

The sum of cash inflows for year 1 and year 2 = $273,600 + $156,000 = $429,600 < $480,000

The sum of cash inflows from year 1 to year 3 = $273,600 + $156,000 + $88,800= $518,400 > $480,000

The payback period is more than 2 years and less than 3 years.

Project B:

The sum of cash inflows from year 1 to year 3 = $68,400 + $80,400 + $177,600 = $326,400< $480,000

The sum of cash inflows from year 1 to year 4 = $68,400 + $80,400 + $177,600 + $405,600 = $732,000 > $480,000

The payback period is more than 3 years and less than 4 years.

Since Project A has a shorter payback period, it should be adopted based on the payback method. c. The net present value represents the net cash profit with the consideration of the time value of money for a particular investment opportunity. The payback period, on the other hand, measures how fast the original investment can be recovered without the consideration of the time value of money. In other words, it is a measurement of the risk of an investment rather than of profitability. Since the two methods measure two different characteristics of investments, neither method is better nor worse than the other one.

If an investor is very concerned about the risk of an investment, he/she should probably use the payback method as the primary decision tool and the net present value method as the secondary tool. Under that circumstance, Project A should be adopted.

If an investor pays the most attention to profitability and is less concerned about the market risk, he/she should use the net present value method as the primary decision tool and the payback method as the secondary tool. Under that circumstance, Project B should be adopted.

Problem 10-20B a.

Year 1 2 3 4 5 Revenues $64,000 $64,000 $64,000 $64,000 $64,000 Depreciation (24,000) (24,000) (24,000) (24,000) (24,000) Income before taxes 40,000 40,000 40,000 40,000 40,000 Income taxes @ 25% (10,000) (10,000) (10,000) (10,000) (10,000) Net income 30,000 30,000 30,000 30,000 30,000 Add back depreciation 24,000 24,000 24,000 24,000 24,000 Cash flow $54,000 $54,000 $54,000 $54,000 $54,000

Net Present Value Table Value Present Value Present value of cash inflows $54,000 x 3.7907871 = $ 204,702 Present value of salvage value 40,000 x 0.6209212 = 24,837 Present value of cash outflows (160,000) Net present value $ 69,539 1Table 2, n = 5, r = 10% 2Table 1, n = 5, r = 10%

Present value index $229,539 / $160,000 = 1.43 b. Year 1 2 3 4 5 Revenues $64,000 $64,000 $64,000 $64,000 $64,000 Depreciation* (64,000) (38,400) (17,600) (0) (0) Income before taxes 0 25,600 46,400 64,000 64,000 Income taxes @ 25% (0) (6,400) (11,600) (16,000) (16,000) Net income 0 19,200 34,800 48,000 48,000 Add back depreciation 64,000 38,400 17,600 0 0 Cash flow $64,000 $57,600 $52,400 $48,000 $48,000 *Double-declining-balance depreciation: Year 1: $160,000 x 2/5 = $64,000 Year 2: ($160,000 – $64,000) x 2/5 = $38,400 Year 3: ($160,000 – $64,000 – $38,400) x 2/5 = $23,040 However, the salvage value is $40,000. $160,000 – $64,000 – $38,400 – $40,000 = $17,600

Net Present Value Table Value* Present Value Present value of cash inflows Year 1 $64,000 x 0.909091 = $ 58,182 Year 2 57,600 x 0.826446 = 47,603 Year 3 52,400 x 0.751315 = 39,369 Year 4 48,000 x 0.683013 = 32,785 Year 5 48,000 x 0.620921 = 29,804 Present value of salvage value 40,000 x 0.620921 = 24,837 Present value of cash outflows (160,000) Net present value $ 72,580 *Table 1, n = 1 – 5, r = 10% Present value index $232,580 / $160,000 = 1.45 c. The net present value and the present value index are higher under double-declining-balance depreciation because the accelerated depreciation delays the cash payment of taxes.

d. Payback $160,000 / $54,000 = 2.96 years Unadjusted rate of return $30,000 / $80,000 = 38%

Alternative giving consideration to salvage value: Unadjusted rate of return $30,000 / $60,000 = 50% e. Average annual cash flow: (1/5) ($64,000 + $57,600 + $52,400 + $48,000 + $48,000) = $54,000

Average annual income: (1/5) ($0 + $19,200 + $34,800 + $48,000 + $48,000) = $30,000

Payback $160,000 / $54,000 = 2.96 years Unadjusted rate of return $30,000 / $80,000 = 38%

Problem 10-20B (continued) Alternative giving consideration to salvage value Unadjusted rate of return $30,000 / $60,000 = 50% f. There is no difference in the payback period or unadjusted rate of return when straight-line versus double-declining-balance depreciation is used because these analytical techniques do not give consideration to the time value of money.

Problem 10-21B a.

Cash Inflows Table Value* Present Value Year 1 $130,800 x 0.909091 = $118,909.10 Year 2 142,572 x 0.826446 = 117,828.06 Year 3 155,404 x 0.751315 = 116,757.36 Year 4 169,388 x 0.683013 = 115,694.21 Cash outflows Cost of investment (500,000.00) Net present value $ (30,811.27) *Table 1, n = 1– 4, r = 10% Since the net present value is negative, Mr. Ruff should not approve purchasing the trucks. b. & c. The cash flow should increase by $36,000 per year ($120,000 x 30%) due to the tax deduction on depreciation. The revised cash flow forecast and the net present value computation should be as follows:

Cash Inflows Table Value Present Value Year 1 $166,800 x 0.909091 = $151,636.38 Year 2 178,572 x 0.826446 = 147,580.12 Year 3 191,404 x 0.751315 = 143,804.70 Year 4 205,388 x 0.683013 = 140,282.67 Cash outflows Cost of investment (500,000.00) Net present value $ 83,303.87

Since the net present value with the revised cash flow is positive, Mr. Ruff should approve purchasing the trucks.

Problem 10-22B a. Unadjusted Rate of Return:

Average increase in net income  Average net cost of original investment $30,000  $135,000 = 22% Since the rate of return under this definition is greater than the required minimum rate of 9%, the company should invest in the project. b. Internal Rate of Return: Present value table factor x $82,500 = $270,000 Present value table factor = $270,000  $82,500 Present value table factor = 3.272727 Looking at Table 2, at row 4, we find the factor 3.272727 to be between 3.312127 and 3.239720; therefore the factor reflects a rate that is between 8% and 9% (approximately 8.5%). Since the internal rate of return is less than the minimum requirement of 9%, the company should reject this project. c. The internal rate of return is the better method for this capital investment decision because the method takes into account the time value of money while the unadjusted rate of return does not.

Problem 10-23B a.

Cash Inflows Table Value Present Value Year 1 $1,840,000 x 0.877193 = $1,614,035 Year 2 1,920,000 x 0.769468 = 1,477,379 Year 3 2,000,000 x 0.674972 = 1,349,944 Year 4 2,400,000 x 0.592080 = 1,420,992 Cash outflows Cost of investment (5,600,000) Net present value $262,350 b.

Cash Inflows Table Value Present Value Year 1 $1,600,000 x 0.877193 = $1,403,509 Year 2 1,520,000 x 0.769468 = 1,169,591 Year 3 2,560,000 x 0.674972 = 1,727,928 Year 4 2,800,000 x 0.592080 = 1,657,824 Cash outflows Cost of investment (5,600,000) Net present value $358,852 c. The postaudit reveals that the original cash flow estimates was inaccurate; however, the original investment objective has been achieved. The actual net present value is about 37% greater than the original expectation. The actual cash flows pattern, though, reflected lower cash inflows in the first two years and substantially greater cash inflow in the last two years.

ATC 10-1 a. Annual savings in heating and cooling costs ($4,200 x 0.30) $ 1,260 x present value factor of a 15 year annuity, at 4% 11.118387 Present value of the annual energy savings $14,009.17

Increase in resale value of the house ($25,000 x 0.70) $ 17,500 x present value factor of $1 in 15 years, at 4% 0.555265 Present value of the increase in resale value 9,717.14 Total present value of buying the windows 23,726.31

Cost of the new windows, today (25,000.00) Net present value of the replacement windows ($1,273.69)

The windows cost more than the present value of their future benefits, so this opportunity has a negative net present value. b. Since the NPV of the windows was negative when computed at 4%, the IRR of the project is obviously something lower. When computed with Excel or a financial calculator, it is revealed to be 3.48%. c. The couple may consider the social responsibilities of each individual, including conserving energy to reduce the greenhouse effect on global warming. They may also consider the factor that a more energy efficient home being more attractive to potential buyers.

ATC 10-2 Computations rounded to nearest whole dollar: Harding Properties

a (1) Cash Inflow Table Value* Present Value Year 1 $ 360,000 0.892857 $ 321,429 Year 2 502,500 0.797194 400,590 Year 3 865,000 0.711780 615,690 Year 3 5,175,000 0.711780 3,683,462 Present value of inflows 5,021,171 Present value of outflows (4,500,000) Net present value $ 521,171 *Table 1, n = 1– 3, r = 12% Present value index $5,021,171 ÷ $4,500,000 = 1.12 Summit Apartments

a (2) Cash Inflow Table Value Present Value Year 1 $ 290,000 0.892857 $ 258,929 Year 2 435,000 0.797194 346,779 Year 3 600,000 0.711780 427,068 Year 3 4,050,000 0.711780 2,882,709 Present value of inflows 3,915,485 Present value of outflows (3,450,000) Net present value $ 465,485

Present value index $3,915,485 ÷ $3,450,000 = 1.13 b. The class should reach the conclusion that the second alternative has the higher rate of return.

ATC 10-2 (continued) c. It would certainly affect the decision. If EREIC decides to invest in Summit Apartments, roughly 23 percent ($1,050,000 ÷ $4,500,000) of the invested funds would be earning a low 5 percent return. The remainder of the investment would earn a return of more than 12 percent. The weighted average return would be approximately: 0.05 x 0.23 = 0.0115 0.13 x 0.77 = 0.1001 Weighted average 0.1116 = 11.2% (rounded) Since this is below the desired rate of return, the investment opportunity would be rejected. The investment in Harding Properties would be earning greater than 12 percent and would be the more attractive alternative. d. There is no definitive answer to this question. However, it should be noted that all of the future cash flows represent estimates that are uncertain. The possibility to obtain additional cash flows definitely adds value. As to whether that value is sufficient to change the selection of the alternative chosen in requirement b will depend on management’s tolerance for risk.

ATC 10-3 a. Excerpt from ADM’s 10-K (Item 1. Business section):

“ During 2006, the Company announced plans to expand its ethanol production capacity by 550 million gallons through the construction of two dry corn milling plants. The Company also announced plans to construct a polyhydroxy alkanoate (PHA) natural plastics production facility, a new U.S. cocoa processing facility, and a U.S. biodiesel production facility. The Company expects to spend approximately $3.1 billion to construct these facilities and other approved capital projects over the next four years.” b. ADM spent $762,009,000 on new property plant, and equipment during its 2006 fiscal year (which happens to be 24.6% of the $3.1 billion it said it planned to spend on the new plants over the next four years). Total cash outflows for investing activities were $1,068,541,000. c. Operating activities generated $1.4 billion in cash, and financing activities provided $283 million. It is worth noting that financing activities include new long-term borrowings of $644 million for 2006. This is significantly higher than the new long-term borrowings for 2005 ($18.5 million), and 2004 ($4.4 million). Also, the $644 million in new debt is in the ballpark of the $762 million spent on new property, plant, and equipment. d. Note 6 states that, “During 2006, the Company issued $600 million of debentures that are due in 2035 and bear interest at 5.375%.”

ATC 10-4 The student’s response should recognize the fact that planning techniques for capital investment are only as good as the estimated data that are used in the analysis. With respect to discounted cash flow techniques, the discount rate or desired rate of return is usually raised when the data involve a great deal of uncertainty. Even so, investing remains a matter of judgment. Indeed, the level of uncertainty can be so great that projected cash flows cannot be reasonably estimated. For example, while many high technology companies will be dissolved before they are able to bear financial fruit, others will become so prosperous that the returns they provide will be astronomical. While these investment opportunities involve so much uncertainty that they do not lend themselves to sophisticated analytical techniques, they nonetheless attract strong investor interest. Numeric financial data is only one input variable that goes into the decision making process. In the case of Webb Publishing, the opportunity to purchase a printing company would be more suitable to analysis with the planning techniques of capital investments. This is so because the cash flows are more predictable. However, this does not mean that the printing business is a better investment than the Internet opportunity, only that it is more suitable to measurement techniques. While measurement of the Internet opportunity may be difficult, it certainly has the potential to provide a dramatic return. The best investment alternative in this case depends on management’s philosophy with respect to the tradeoff between risk and reward. The limitations associated with general risk assessment apply to less sophisticated techniques such as payback and unadjusted rate of return as well as the discounted cash flow techniques. ATC 10-5 a. Present Value Table Factor (a) 3.790787 (Table 2, 10%, 5 Years) Actual Projected Projected Cash inflows (b) $91,000 $90,000 $70,000 Present value (a x b) $344,961.62 $341,170.83 $265,355.09 Cost of investment (250,000.00) (250,000.00) (250,000.00) Net present value $ 94,961.62 $ 91,170.83 $ 15,355.09

ATC 10-5 (continued)

Bonus if $90,000 is used as the projected annual cash inflow: $94,961.62  $91,170.83 = $3,790.79 x 0.10 = $379.08

Bonus if $70,000 is used as the projected annual cash inflow: $94,961.62  $15,355.09 = $79,606.53 x 0.10 = $7,960.65 b. Mr. Holt may not be a member of the Institute of Management Accountants and therefore may not be bound by the organization’s ethical standards though he is clearly unethical. Regardless, his behavior is in violation of many of the standards including: his behavior violates the integrity standards to: (1) avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict, (2) refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically, and (3) refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives. c. The bonus plan encourages managers to consistently underestimate cash inflows and to reject investment opportunities for which real cash flows approach the company’s desired rate of return. In essence this acts to raise the effective desired rate of return. In other words there is no bonus for a project that provides a real return that is equal to the desired rate of return. The motive to misrepresent cash flows corrupts the moral integrity of management which is likely to manifest itself in other corrupt practices. The raising of the desired rate of return could lead to a scarcity of investment opportunities. d. The bonus plan should seek to motivate accuracy in reporting. A motive to underestimate cash flows is just as detrimental as a motive to overestimate. The objective is accuracy. Many potential reward systems are possible. One example would be to provide a bonus to managers who minimize the variance between actual and budgeted net present value.

ATC 10-6

Screen capture of cell values:

ATC 10-6

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ATC 10-7

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ATC 10-7

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ATC 10-7

Screen capture of cell formulas (continued):

Chapter 10 -- Comprehensive Problem a.

Opportunity A B C D Cash inflow $6,000 $5,000 $8,000 $4,800 Times present value factor 2.798181 3.274294 2.245890 3.274294 Present value of cash flows $ 16,789.09 $16,371.47 $17,967.12 $15,716.61 Minus cost of investment (16,000.00) (15,000.00) (18,000.00) (16,000.00) Net present value $ 789.09 $1,371.47 ($32.88) ($283.39)

Investment Data Time period 4 Cash inflow -- incremental revenue 6,000 Cash outflow -- Cost of investment (16,000) (Note: The cash outflow must be Desired rate of return 0.16 entered with a minus sign.)

Results Internal rate of return 18.45% Net present value $789.09

Summary of Results Opportunity A B C D Net present value $789.09 $1,371.47 ($32.88) ($283.39) Internal rate of return 18.45% 19.86% 15.89% 15.24%