MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual

CHAPTER 20
CAPITAL BUDGETING DECISIONS
I. Questions
1. A capital investment involves a current commitment of funds with the
expectation of generating a satisfactory return on these funds over a
relatively extended period of time in the future.
2. Cost of capital is the weighted minimum desired average rate that a
company must pay for long-term capital while discounted rate of return is
the maximum rate of interest that could be paid for the capital employed
over the life of an investment without loss on the project.
. !he basic principles in capital budgeting are"
1. Capital investment models are focused on the future cash inflows and
outflows - rather than on net income.
2. Investment proposals should be evaluated according to their
differential effects on the company#s cash flows as a whole.
. $inancing costs associated with the project are excluded in the
analysis of incremental cash flows in order to avoid the %double-
counting& of the cost of money.
'. !he concept of the time value of money recogni(es that a peso of
present return is worth more than a peso of future return.
). Choose the investments that will maximi(e the total net present value
of the projects subject to the capital availability constraint.
'. !he major classifications as to purpose are"
1. *eplacement projects
- those involving replacements of worn-out assets to avoid
disruption of normal operations+ or to improve efficiency.
2. ,roduct or process improvement
- projects that aim to produce additional revenue or to reali(e cost
savings.
. -xpansion
- projects that enhance long-term returns due to increased profitable
volume.
). .reater amounts of capital may be used in projects whose combined
returns will exceed any alternate combination of total investment.
20-1
Chapte 20 Capital Budgeting Decisions
/. 0o. !his implies that any e1uity funds are cost free and this is a
dangerous position because it ignores the opportunity cost or alternative
earnings that could be had from the fund.
2. 3es+ if there are alternative earnings foregone by stoc4holders.
II. Matching Type
1. A /. 5
2. C 2. 6
. $ 7. .
'. 8 9. :
). I 1;. -
III. Problems
!o"le# 1 (E$uip#ent %epla&e#ent Sensiti'it( Anal(sis)
Requirement 1
Total Present Value
A. 0ew <ituation"
*ecurring cash operating costs =,2/+);; x 2./9> , 21+27)
Cost of new e1uipment ''+;;;
6isposal value of old e1uipment now =)+;;;>
,resent value of net cash outflows ,11;+27)
8. ,resent <ituation"
*ecurring cash operating costs =,')+;;; x 2./9> ,121+;);
6isposal value of old e1uipment four years hence
=,2+/;; x ;.)1/> =1+'2>
,resent value of net cash inflows ,119+2;7
6ifference in favor of replacement , 9+'2
Requirement 2
,aybac4 period for the new e1uipment ?
? 2.1 years
Requirement 3
@et A ? annual cash savings
@et B ? net present value
20-2
,''+;;; C ,)+;;;
,17+);;
Capital Budgeting Decisions Chapte 20
A =2./9> D ,)+;;; - ,''+;;; - ,1+'2 ? B
2./9A ? ,';+'2
A ? ,1'+992
If the annual cash savings decrease from ,17+7); to ,1'+992 or by ,+);+
the point of indifference will be reached.
Another alternative way to get the same answer would be to divide the net
present value of ,9+'2 by 2./9;.
!o"le# 2
Annual cash expenses of the manual boo44eeping
machine system+ ,9+7;; x 12 ,112+/;;
Annual cash expenses of computeri(ed data processing )+/;;
Annual cash savings before taxes , /'+;;;
Year 1 Year 2 Year 3
Annual cash savings =a> ,/'+;;; ,/'+;;; ,/'+;;;
6epreciation 2;+;;; 1/+;;; 12+7;;
Inflow before tax ,''+;;; ,'7+;;; ,)1+2;;
Income tax =);E> =b> 22+;;; 2'+;;; 2)+/;;
Cash inflow after tax =a - b> ,'2+;;; ,';+;;; ,7+';;
After Tax
Cash Inflows PV Fator PV
3ear 1 ,'2+;;; x ;.9;9 , 7+127
3ear 2 ';+;;; x ;.72/ +;';
3ear 7+';; x ;.2); 27+7;;
3ear <alvage 2;+;;; x ;.2); 1)+;;;
3ear !ax loss 1)+/;;F x ;.2); 11+2;;
,12/+217
Investment =I> 1;;+;;;
0et present value =0,G> , 2/+217
HHHHHHHHHHHHHHHHH
F !he ,1)+/;; tax benefit of the loss on the disposal of the computer at the end of
year is computed as follows"
-stimated salvage value , 2;+;;;
-stimated boo4 value"
5istorical cost ,1;;+;;;
Accumulated depreciation '7+7;; )1+2;;
-stimated loss ,=1+2;;>
20-)
Chapte 20 Capital Budgeting Decisions
!ax rate );E
!ax effect of estimated loss ,=1)+/;;>
<ince the net present value is positive+ the computer should be purchased
replacing the manual boo44eeping system.
!o"le# )
Requirement 1
=a> ,urchase price of new e1uipment ,=;;+;;;>
6isposal of existing e1uipment"
<elling price , ;
8oo4 value /;+;;;
@oss on disposal ,/;+;;;
!ax rate ;.'
!ax benefit of loss on disposal 2'+;;;
*e1uired investment =I> ,=22/+;;;>
=b> Increased cash flows resulting from
change in contribution margin"
Ising new e1uipment J17+;;; =,2; - ,2>K F ,2'+;;;
Ising existing e1uipment J11+;;; =,2; - ,9>K 121+;;;
Increased cash flows 11+;;;
@ess" !axes =;.'; x ,11+;;;> ')+2;;
Increased cash flows after taxes , /2+7;;
6epreciation tax shield"
6epreciation on new e1uipment
=,;;+;;; )> ,/;+;;;
6epreciation on existing e1uipment
=,/;+;;; )> 12+;;;
Increased depreciation charge ,'7+;;;
!ax rate ;.';
6epreciation tax shield 19+2;;
*ecurring annual cash flows , 72+;;;
HHHHHHHHHHHHHHHHH
F !he new e1uipment is capable of producing 2;+;;; units+ but -!C ,roducts
can sell only 17+;;; units annually.
!he sales manager made several errors in his calculations of re1uired
investment and annual cash flows. !he errors are as follows"
Require! in"estment#
20-*
Capital Budgeting Decisions Chapte 20
- !he cost of the mar4et research study =,''+;;;> is a sun4 cost because it
was incurred last year and will not change regardless of whether the
investment is made or not.
- !he loss on the disposal of the existing e1uipment does not result in an
actual cash cost as shown by the sales manager. !he loss on disposal
results in a reduction of taxes+ which reduces the cost of the new
e1uipment.
Annual ash flows#
- !he sales manager considered only the depreciation on the new e1uipment
rather than just the additional depreciation which would result from the
ac1uisition of the new e1uipment.
- !he sales manager also failed to consider that the depreciation is a noncash
expenditure which provides a tax shield.
- !he sales manager#s use of the discount rate =i.e.+ cost of capital> was
incorrect. !he discount rate should be used to reduce the value of future
cash flows to their current e1uivalent at time period (ero.
Requirement 2
,resent value of future cash flows =,72+;;; x ./> ,292+2;
*e1uired investment =I> 22/+;;;
0et present value , 1/+2;
!o"le# *

Requirement 1# ,=);2+;;;>
Requirement 2# ,='//+2;;>
Requirement 3# ,=2+';;>
IG. Multiple Choice Questions
1. 6 11. 6 21. C 1. 6
2. C 12. 6 22. 8 2. C
. 8 1. 6 2. C . C
'. 8 1'. C 2'. 6 '. 6
). A 1). C 2). C ). 6
/. C 1/. 6 2/. C /. 8
2. 6 12. 6 22. 6 2. 8
7. 8 17. 8 27. 8 7. 8
20-+
Chapte 20 Capital Budgeting Decisions
9. 8 19. A 29. 6 9. 6
1;. A 2;. A ;. A ';. 8
20-,