Professional Documents
Culture Documents
COMPLEXITY SYMBOLS
The textbook uses a coding system to identify the complexity of individual requirements in the
exercises and problems.
Questions Having a Single Correct Answer:
No Symbol
This question requires students to recall or apply knowledge as shown in the
textbook.
This question requires students to extend knowledge beyond the applications
e
shown in the textbook.
Open-ended questions are coded according to the skills described in Steps for Better Thinking
(Exhibit 1.10):
QUESTIONS
12.1
After a number of years, the present value factors for all discount rates become quite
small, and the incremental affect of future cash flows is therefore small. According to the
present value tables, after about 15 years, the incremental values at rates above 8 to 10%
are small (less than 20% of the original value). If these cash flows are small, but include
error, the size of error would also be small and likely have little effect on the overall
analysis.
12.2
If several projects are being analyzed, their NPVs can be summed to determine the NPV
for that group or portfolio of projects, whereas IRR can be neither summed nor averaged.
In addition, NPV provides information about the value of the projects in terms of todays
dollars. If projects are of different sizes, requiring large and small investments, NPV
reflects these differences. IRR provides only a rate of return, and comparing rates of
return does not take into consideration the size of return. In addition, the net present
value method is computationally simpler than the internal rate of return method.
Determining IRR can be time consuming, particularly for projects having uneven cash
flows. However, the use of a spreadsheet reduces the effort considerably.
An important difference between the two methods is that the IRR method assumes cash
inflows can be reinvested to earn the same return that the project would generate.
However, it may be difficult for an organization to identify other opportunities that could
achieve the same rate when IRR is high. In contrast, the NPV method assumes that cash
inflows can be reinvested and earn the discount ratea more realistic assumption. If the
discount rate is set equal to the organizations cost of capital, then alternative uses of cash
would include paying off creditors or buying back stock. Therefore, if the results of
analyses using the two methods are not the same, the NPV method is preferable.
Both methods are used widely in business. One reason for the continued use of IRR is
that many people find it intuitively easier to understand than NPV. In addition, managers
may want to compare the IRR on prior projects to current project return rates as they
consider new investment.
12.3
(a) Net present value (NPV)
Pros:
NPV is more accurate than the payback and accrual accounting rate of return
methods because it reflects the time value of money.
Under NPV, discounted cash flows reflect todays dollars, so several different
projects can be easily compared to determine the one with the highest NPV.
Cons:
It is sometimes more difficult to estimate cash flows and choose an
appropriate discount rate for NPV than finding the internal rate of return or
calculating payback or an accounting rate of return.
Estimating future cash flows becomes more difficult over longer periods of time because
the uncertainties increase. Changes in economic, political, and consumer tastes that
affect cash flows cannot be easily predicted. More information is usually available about
near-term economic factors than long-term.
12.5
Future cash flows are discounted with present value factors that become increasingly
small across time to reflect the fact that investors forego interest on cash flows that are
received in the future relative to cash flows that are received today and could be invested
today. This discounting reflects the opportunity cost (interest foregone) when money is
received in the future instead of today.
12.6
A nominal discount rate includes a factor for inflation, and the real rate does not. Both
rates include a risk-free rate and a risk premium. Using a nominal approach, different
cash flows can be inflated differentially. For example, gasoline prices might inflate at a
different rate than wages. If different types of cash flows are differentially inflated to
better reflect future expectations, the preciseness of the estimation and analysis process
increases and information quality increases.
12.7
Real assets tend to increase in nominal value under inflation, while monetary assets tend
to remain fixed. If a firm has cash in a bank earning interest, the after-tax return could be
less than the inflation rate. Therefore the firms cash would be losing purchasing power
over time. In this case it would be better for the firm to invest in a real asset that
increases at the inflation rate or greater.
12.8
Net present value. All investments with a positive net present value would be accepted,
assuming that the cost of capital is constant across investments.
12.9
Requiring a higher return rate for projects in developing countries may be the firm's way
of coping with increased problems of uncertainty and risk. Less developed countries
usually have less stable political systems, economies, inflation rates, and consumer
markets. In addition, infrastructure such as roads and utilities is sometimes unreliable, so
production and transportation problems could occur more frequently. These factors
increase the risk of doing business in developing countries.
From the host government's point of view, if a higher rate of return is not permitted under
such circumstances, the investment would probably never have been made at all, and the
developing country would be worse off as a result. The firm, however, must be careful to
avoid any perception of exploitation, as the long-term reputation effect could be
devastating.
12.10 There are two reasons to incorporate tax effects more formally into NPV analyses. From
an accounting standpoint, tax regulations permit a shift of both the amount and the timing
(sometimes permanently) of taxes; this will have an effect on present values. If tax
savings based on current tax rules are not incorporated into the analysis, these effects are
not captured and the analysis is less accurate. From a mathematical standpoint, the
factors in the tables are not linearly related (all of the formulas have exponents); e.g., the
present value factor for 20% is not one-half of the factor for 10%.
12.11 The return on the investment portfolio represents the clinic's opportunity cost for funds.
They can earn at least that return; therefore, any other investment must yield a higher
return.
EXERCISES
12.12 Time Value of Money
A. Using tables, the answer is ($8,000 x 0.583) = $4,664.
Using Excel, the answer is $4,667.92.
B. Using the tables, the answer is ($125 x 1.791) = $223.88.
Using Excel, the answer is $223.86.
C. Using tables, the answer is ($10,000 x 0.747) = $7,470.
Using Excel, the answer is $7,472.58.
D. Using tables, the answer is ($1,000 x 0.507) = $507.
Using Excel, the answer is $506.63.
12.13 Capital Budgeting Process
The proper sequence is: 4, 1, 5, 2, 3, and 6.
12.14 Overnight Laundry
Cash Flow Timeline:
Investment
Incremental cash flows:
Annual Savings
Taxes
Net cash flow
Terminal value
Time 0
$(96,000)
Years1-10
Year 10
$25,000
(5,128) (a)
$19,872
$6,000
(a) The salvage value is ignored for income tax depreciation, so the annual
depreciation = $96,000/10 years = $9,600 per year
Taxes per year = ($25,000 - $9,600) * 33.3% = $5,128
NPV calculation:
NPV = $(96,000) + $19,872 (PVFA 18%, 10 years) + $6,000 (PVF 18%, 10 years)
= $(96,000) + ($19,872 x 4.494) + ($6,000 x0.191)
= $(96,000) + $89,305 + $1,146
= ($5,549)
Time 0
$(100,000)
Years1-5
Year 10
$20,000 (a)
(0) (b)
$20,000
$0
Investment
Incremental cash flows:
Annual contribution margin
Incremental fixed costs
Incremental taxes
Net cash flow
Terminal value
Years1-5
Year 10
$2Q (a)
(20,000)
($0.5Q - $5,000) (b)
$1.5Q - $15,000
(a) Annual contribution margin per case (Q) = ($9 - $7)Q = $2Q
(b) Depreciation = $100,000/5 years = $20,000 per year
Incremental Taxes = ($2Q $20,000) * 25%
= $0.5Q - $5,000
$0
Year
1
2
$18,000 $18,000
4,000
4,000
$22,000 $22,000
3
4
5
6
$18,000 $18,000 $18,000 $18,000
4,000
4,000
4,000
4,000
$22,000 $22,000 $22,000 $22,000
Calculation details:
Annual after-tax savings = $30,000 * (1-0.40) = $18,000
Straight-line depreciation = $60,000/6 years = $10,000 per year
Depreciation tax savings per year = $10,000 * 0.40 = $4,000
NPV calculation:
NPV = -$60,000 + $22,000 x (PVFA 10% 6 years)
NPV = -$60,000 + $22,000 x 4.355 = $35,810
C. To determine the payback period, first summarize the cumulative cash flows from the
project:
Year
1
2
3
The original investment is $60,000, which is expected to be paid back between 2 and 3
years. If the cash flows are assumed to occur evenly throughout each year, the payback
period is 2.73 years [(2 + (60,000 - 44,000)/22,000)]. Because cash flows are identical
across years, the payback can also be calculated as follows: $60,000/$22,000 = 2.73
years.
Years 1-5
$(20,000)
12,000 (a)
$ (8,000)
Years 6-15
$(20,000)
6,000 (b)
$(14,000)
$(100,000)
(95,354)
21,630
$(173,724)
Time 0
$(150,000)
Years 1-5
$(10,000)
12,000 (a)
$ 2,000
Years 6-15
$(10,000)
3,000 (b)
$ (7,000)
$(150,000)
(47,677)
32,445
$(165,232)
$(100,000)
(136,220)
$(236,220)
$(150,000)
(68,110)
$(218,110)
The answer depends on management's time-frame used in the budget process. If the notfor-profit organization intends to occupy the building for the next 15 years, alternative 2
is still the best choice. However, management may concern itself only with current year
outlays (a focus of many governmental units). In that case, alternative 1 might be chosen
because its initial cost is $50,000 less than alternative 2's. Although this is a common
approach, one might question whether it is "proper."
12.23 Garco
A.
Initial net investment (1,000,000 - 60,000)
Annual savings 300,000
Net present value
Present Value
Factor
1.00
3.605
Present
Value
$ (940,000)
1,081,500
$ 141,500
B. First calculate the present value factor for an annuity of 5 payments that equates the cash
inflows and outflows:
$300,000 * F = 940,000
F = 3.13333
A factor of 3.13333 represents an internal rate of return of slightly less than 18%.
A spreadsheet could be used to determine the exact answer of 17.913%.
C. Assuming the cash flows take place evenly throughout the year:
$940,000/$300,000 = 3.13 years
PROBLEMS
12.24 Jackson
[Note about problem complexity: Item B is not coded as Step 3 because this is explicitly
discussed in the chapter.]
A. The choices are (1) hold the stock and work for $90,000 per year or (2) sell the stock, do
not take the job, and start the restaurant. This is a long-term decision.
B. Either IRR or NPV methods could be used for this analysis. The decision is a long-term
decision and therefore needs to include the time value of money. Both of these methods
do that. With the NPV method, inflation rates for different categories of costs could be
used, so the results would be more precise. In addition, it may be easier to understand the
differences in these two plans in todays dollars, rather than in rates of returns.
C. His opportunity costs are $90,000 plus benefits from the job offer, plus the return on the
stock.
D. The following categories would be set into an input box: Investment amount, risk free
rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates,
all of the cash flows from the restaurant (revenues and variable and fixed costs). Once
these are in the input box, formulas for calculating the incremental cash flows over time
need to be set up, and the real cash flows would need to be inflated and then discounted.
If depreciation is relevant for the investment, a MACRS table would need to be added.
E. Uncertainties about a new job include lack of information about the people Jackson
would work with, and also about the nature of the work to be done. The future of the
company is not guaranteed. Students may have thought of other uncertainties.
F. Jackson faces uncertainties about customer preferences, which will result in uncertainty
about revenues. He has not operated a restaurant, so he faces uncertainties about current
costs and cost trends over time. He also faces uncertainties about the quality and quantity
of employees available to cook, wait tables, and perform other tasks that need to be done.
G. Jackson faces many uncertainties, no matter which alternative he chooses. If he performs
sensitivity analyses around each alternative and formally incorporates qualitative factors,
such as the amount of enjoyment he takes in his current position and his perceptions of
this aspect of owning a restaurant, he will be able to make a high quality decision.
Disadvantages
investment.
It is easy to explain
It can be calculated using a spreadsheet
B. The discount rate should be different for every project because the risk of every project is
different. Part of the discount rate is the risk premium, and that should be higher for
projects that are riskier.
C. For discount rates, the following information would be helpful: current and historical
inflation rates and T-bill rates. In addition, historical financial information about the
three alternative projects or similar projects in similar would be important to develop the
risk premium. Information about demand for rooms, apartments, and boxes would be
needed. Information about the availability of management and employees for the three
alternatives would be useful.
D. The answer to this question depends in part upon the assumptions made about the current
operations of the homeless shelter. If the shelters current operations are similar to an
apartment complex, the second alternative is probably least risky because of the rent
subsidization, the first alternative next most risky, and the manufacturing operation most
risky. Information about demand and employee stability is likely to be more uncertain
than information about occupancy rates, etc. However, if the homeless shelter is just a
large space with cots for homeless people, the managers experience may be irrelevant
when considering risk.
The amount of financial risk also depends on the size of investment. The managers need
to consider potential problems that could affect financial outcomes. A hotel that offers
rooms based on ability to pay could attract people who are using the hotel for illegal
activities and require a great deal of monitoring. Alternatively, the manufacturing
operation requires managers who are trained to work with homeless people and skilled at
managing manufacturing operations. To better understand the financial risks for the three
different types of operations, the managers may want to find similar businesses in the
local area and examine their revenues and expenses across time. Managers of not-forprofit organizations are often willing to share information with each other.
Time 0
$(20,000)
Years1-5
Year 5
$6,000 (a)
(500) (b)
$5,500
$0
$ 101,626
$(110,000)
$ (8,374)
B.
Inflation rate
Nominal rate
Income tax rate
Initial investment
Terminal cash flow
Incremental operating cash flow
$
$
$
5%
18.0%
25%
110,000
36,000
Period
Incremental Operating Cash Flows
Inflated
Less taxes
1
$36,000
2
$36,000
3
$36,000
4
$36,000
5
$36,000
$37,800
-$9,450
$39,690
-$9,923
$41,675
-$10,419
$43,758
-$10,940
$45,946
-$11,487
28,350
20.00%
22,000 $
$5,500
32.00%
35,200 $
$8,800
28,350
$5,500
33,850
29,768
$8,800
38,568
$
$
Present value
Sum of annual cash flows
Less initial investment
Net present value
$28,686
$
$
$
$
$
29,768
$27,699
$
$
31,256
34,460
19.20%
21,120 $
$5,280
11.52%
12,672 $
$3,168
11.52%
12,672
$3,168
31,256
$5,280
36,536
32,819
$3,168
35,987
34,460
$3,168
37,628
$22,237
$
$
32,819
$18,562
$
$
$16,447
113,631
110,000
3,631
C. When the cash flows are inflated, the discount rate and cash flows are valued consistently
in nominal terms. Therefore incorporating inflation increases the accuracy of the
analysis. Using a nominal discount rate with real cash flows underestimated the cash
flows and understated the net present value.
B. Any assumptions are uncertain. These include all of the variables in the analysis. They
are all uncertain because they are all affected by changes in the economy, changes in
consumer patterns, and changes in technology, among others.
C. Technology changes could reduce the effectiveness of the diagnostic equipment over
time. If there are rapid and unexpected changes in technology, the equipment could
become obsolete relatively quickly. People will have older computers that need work,
but the service division may not be able to use the equipment on newer machines, and
have to buy new equipment sooner than expected. This would lead to decreases in
revenues prior to purchase of new equipment and increases in costs over time when
newer equipment is purchased.
D. All of the variables in the input section can be varied. Students should use their judgment
to determine the factors that are most likely to change rapidly, and the amounts by which
they will change.
E. The answer will vary depending on the factors and range of values used. The purpose of
this question is to encourage students to learn more about NPV and sensitivity analysis by
exploring how fluctuations in different factors affect NPV results. Students may have
difficulty deciding (1) which factors are likely to have a significant effect, and (2) how
It may reduce the amount of time that machines are in the shop.
Cons
Kelly does not know for certain whether the diagnostic machine will
reduce costs as much as anticipated.
The equipment could break down more often than expected.
Employees may need special training and, if employee turnover is
high, this could be a problem.
G. There is no one answer to this part. Sample solutions and a discussion of typical student
responses will be included in assessment guidance on the Instructors web site for the
textbook (available at www.wiley.com/college/eldenburg).
12.31 The Hotshots
A. Following is the time line incorporating the algebraic approach to the solution. Notice
that S is used for salary because the problem gives no information about its value. Nor
does the problem provide information about the tax consequences of buying the house.
Following are two solutions using two different assumptions. The first solution assumes
no tax consequences for the $5 million house. The second solution assumes that the
house could be amortized as a business expense over 4 years (the length of the contract).
Solution #1: Cash Flow Timeline
Investment
Incremental cash flows:
Incremental revenues
Incremental salary
Incremental taxes
Net cash flow
Time 0
$(13,000,000)
Years1-4
$6,000,000
(S)
$(800,000) + 0.20S
$5,200,000 0.80S
(a)
(b)
Time 0
$(13,000,000)
Years1-4
$6,000,000
(S)
$(550,000) + 0.20S
$5,450,000 0.80S
(a)
(b)
Are there other competing sports in the area that are played at the same time,
for example college team sports?
Does Bob have a dubious reputation that could lead to behavior that would
turn fans against him and the team?
Will other team mates resent having a highly paid team member when their
salaries may not be nearly as high?
If the team does not have a winning season, even after Bob has been signed,
will attendance fall off?
D. The signing bonus and the cost of housing for Bob would be certain once the contract is
signed. However, there is uncertainty about the incremental revenue cash flows. For
example, Cliff cannot know whether fans will react to Bob in the way these estimates
predict. It is possible that bad publicity could arise about Bobs behavior, which could
change the expected increases in revenues. Fans can be unpredictable, and this could
change the revenues greatly. Bob could become injured, and fan support would decrease.
It is possible that a competing sport will reduce the amount of expected revenues. There
is also uncertainty about the income tax cash flows. Income tax regulations could
change, altering the tax rate or the deductibility of costs.
12.32 Wildcat Welders, Inc.
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at www.wiley.com/college/eldenburg).
A. Below is an excerpt from the sample spreadsheet showing calculations under the nominal
method. The NPV for the project is $8,101,087.
B. Worker safety could easily override a negative NPV value. In addition, sometimes
insurance companies will no longer insure individuals or businesses if they do not
manage their risk of liability claims well. For example, homeowners insurance is
cancelled for people who own certain breeds of dogs that are known to bite people after
the first claim.
C.
1. Students will have a number of different responses to this question. However, their
logic should include the fact that this is replacement of equipment, which tends to be
A. ($22,900)
B. ($15,288)
C. ($31,323)
D. $5.79
E. $6,701
F. ($22,497)