Chapter 11

Capital Budgeting

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be
able to:

1. Describe capital budgeting decisions and use the net present value
(NPV) model to make such decisions.

2. Evaluate projects using sensitivity analysis.

3. Calculate the NPV difference between two projects using both the
total projects and differential approaches.

4. Identify relevant cash flows for NPV analyses.

5. Compute the after-tax net present values of projects.

6. Explain the after-tax effect on cash of disposing of assets.

7. Compute the impact of inflation on a capital-budgeting project.

8. Use the payback model and the accounting rate-of-return model

and compare them with the NPV model.

9. Reconcile the conflict between using an NPV model for making a

decision and using accounting income for evaluating the related
performance.

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10. Understand how companies make long-term capital investment
decisions and how such decisions can affect the companies
financial results for years to come.

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CHAPTER 11: OVERVIEW
This chapter provides an introduction to capital budgeting, the
investment in assets or projects that last more than one year. The roles of
depreciation and are discussed.

Section One: Provides a discussion of the program or project

orientation of capital investment decisions compared to
the period-by-period evaluations of operations performed
for divisions, departments, and other segments in
organizations.

Section Two: Provides an introduction to discounted-cash-flow

methods of evaluating capital investments. The net
present value (NPV) method is developed and discussed.
Selecting discount factors from present value tables, the
impact of depreciation, and assumptions of the DCF
models are also presented.

Section Three: Examines risk assessment and the use of sensitivity

analysis in DCF analyses.

Section Four: Comparing two alternatives using the NPV method is

discussed. The total project approach and the differential
approach are illustrated.

Section Five: The effects of depreciation on investment decisions are

discussed. The tax shield or tax savings resulting from
depreciation are emphasized. Also, the impact of gains
and losses on the disposition of assets on capital-budgeting
decisions is examined.

Section Six: The confusion that sometimes occurs regarding the

handling of "book values" and "depreciation" is examined.
Book values are ignored in capital budgeting analysis.
However, they are considered when determining the
taxable gain or loss from disposing of an asset. Only the
tax savings resulting from the depreciation deduction
should be included in the analysis.

Section Seven:The handling of inflation in capital investment decisions

is explained. If a market interest rate is used as the
minimum desired rate of return, this rate includes an
inflation component. Therefore, if a market rate is used,

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 cash flows must be adjusted for inflation. If a real interest
rate is used, inflation adjustments are not necessary.
Whatever rate is used, the tax savings from depreciation
need not be adjusted since it is set based on the
acquisition cost of the asset at time zero.

Section Eight: Explores the non-DCF techniques for analyzing capital

investments. The payback and accounting rate-of-return
methods are shown and drawbacks explained.

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CHAPTER 11: ASSIGNMENTS

EXERCISES

26 Exercise in Compound Interest

27 Exercise in Compound Interest
28 Exercise in Compound Interest
29 Basic Relationships in Interest Tables
30 Present Value and Sports Salaries
31 Simple NPV
32 New Equipment
33 Present Values of Cash Inflows
34 Sensitivity Analysis
35 NPV and Sensitivity Analysis
36 Depreciation, Income Taxes, Cash Flows
37 After-Tax Effect on Cash
38 MACRS Depreciation
39 Present Value of MACRS Depreciation
40 Inflation and Capital Budgeting
41 Sensitivity of Capital Budgeting to Inflation
42 NPV, ARR, and Payback
43 Comparison of Capital-Budgeting Techniques

PROBLEMS

44 Replacement of Office Equipment

45 Replacement Decision for Railway Equipment
46 Discounted Cash Flow, Uneven Revenue Stream, Relevant
Costs
47 Investment in Machine and Working Capital
48 Replacement Decision
49 Minimization of Transportation Costs Without Income
Taxes
50 Straight-Line and MACRS Depreciation, and Immediate
Write-Off
51 MACRS, Residual Value
52 Purchase of Equipment
53 Minimization of Transportation Costs After Taxes, Inflation
54 Inflation and Nonprofit Institution
55 MACRS and Low-Income Housing
56 Present Value of After-Tax Cash Flows, Payback, and ARR
57 Fixed and Current Assets: Evaluation of Performance
58 Deer Valley Lodge

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CASES

59 Investment in CAD/CAM
60 Investment in Technology
61 Investment in Quality
62 Make or Buy and Replacement of Equipment

COLLABORATIVE LEARNING EXERCISE

63 Capital Budgeting, Sensitivity Analysis, and Ethics

64 Internet Exercise - http://www.carnivalcorp.com

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CHAPTER 11: OUTLINE
I. Capital Budgeting For Programs Or Projects

Capital-Budgeting - long-term planning for making and financing

investments that affect financial results over more than just the
next year. This chapter concentrates on the planning and
controlling of programs or projects that affect more than one year's
financial results. The investments required for programs or projects
are often called capital outlays. Accountants are information
specialists (i.e., gather and interpret information). Capital
budgeting has three phases:

1. Identifying potential investments,

2. Choosing which investments to make, and
3. Follow-up monitoring of the investments.

II. Discounted-Cash-Flow Models

Discounted-Cash-Flow (DCF) Models - focus on a projects cash

inflows and outflows while taking into account the time value of
money. DCF models are used by more than 85 percent of the large
industrial firms in the United States and are the best measures of
the financial effects of an investment.

A. Major Aspects of DCF

DCF models focus on expected cash inflows and outflows

rather than on net income and are based on the theory of
compound interest. A brief summary of the tables and
formulas used is included in APPENDIX B at the end of the
book.

B. Net Present Value (NPV) {L. O. 1}

Net-Present-Value (NPV) Method - a DCF approach to
capital budgeting that computes the present values of all
expected future cash flows using a minimum desired rate of
return. The Required Rate Of Return, Hurdle Rate,
Discount Rate, or Cost Of Capital - the minimum desired
rate or return. It is selected by the manager based upon the
projects risk level. If the sum of the present values of all the
expected cash flows is positive, the project is desirable and
vice versa. A zero NPV leaves the decision maker indifferent

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between accepting and rejecting the project (i.e., break even).

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C. Applying the NPV Method

See EXHIBIT 11-1 for an example of the three steps in

applying the NPV method:

1. Prepare a diagram of relevant expected cash inflows

and outflows (right-hand side of EXHIBIT 11-1).

2. Find the present value of each expected cash inflow or

outflow (see APPENDIX B).

3. Sum the individual present values.

D. Choice of the Correct Table

Students should be shown the relationship between and

proper use of the tables appearing in APPENDIX B. TABLE 1
should be used in discounting single amounts, while TABLE 2
is used for a series (i.e., annuities) of equal amounts. The
factors in TABLE 2 are simply summations of the factors from
TABLE 1.

E. Effect of Minimum Rate

The minimum desired rate of return can have a large effect on

NPVs. The higher the minimum desired rate of return, the
lower the present value of each future cash inflow and the
lower the NPV of the project. Investments that are desirable at
one rate of interest may be undesirable at a higher rate of
interest.

F. Assumptions of the NPV Model

First, we act as if the predicted cash inflows and outflows will

occur at the times specified. Second, we assume perfect
capital markets (i.e., borrow or lend money at the same
interest rate - minimum desired rate of return for the NPV
model). The use of DCF models also passes the cost-benefit
test.

G. Depreciation and NPV

We are concerned with cash flows, not revenues and

expenses. Depreciation is an expense that does not require a
current cash outlay. The entire cost of an asset is typically a

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lump-sum outflow of cash at time zero. Deducting
depreciation from operating cash flows would be a double-
counting of a cost that has already been considered a lump-
sum outflow.

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 H. Review of Decision Rules

NET-PRESENT VALUE (NPV) MODEL - Comparison by

expressing all amounts in todays monetary units at time zero.

1. Calculate the NPV using the minimum desired rate of

return as the discount rate.

2. If the NPV is positive, accept the project, and vice versa.

III. Sensitivity Analysis and Risk Assessment in DCF

Models {L. O. 2}
Sensitivity Analysis - shows the financial consequences that
would occur if actual cash inflows differed from those expected.
This approach of incorporating risk in capital-budgeting decisions
answers "what-if" questions concerning the values of NPV when the
cash flows, useful life, or minimum desired rate of return are
changed. The two major types of sensitivity analysis are: (1)
comparing the optimistic, pessimistic, and most likely predictions
and (2) determining the amount of deviation from expected values
before a decision is changed. Sensitivity analysis shows how risky a
project might be by showing how sensitive it is to change.

IV. The NPV Comparison of Two Projects {L. O. 3}

A. Total Project versus Differential Approach

Total Project Approach - compares two or more

alternatives by computing the total impact on cash flows of
each alternative and then computing NPVs for each
alternative. The project with the largest NPV of total cash
flows is preferred. Differential Approach - two alternatives
are compared by computing the differences in cash flows
between two alternatives and then computing the NPV of
those differences. The differential approach is limited to
comparing two projects at a time, while the total project
approach can be used for more than two alternatives. Cash
inflows are positive and cash outflows are negative in an
analysis. See EXHIBIT 11-2 for an illustration of the two
methods for a keep or replace decision.

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B. Relevant Cash Flows for NPV. {L. O. 4}
Typical items to be included in a NPV analysis are:

1. Initial cash inflows and outflows at time zero.

Included here are outflows for the purchase and
installation of equipment and other items required by
the new project, and either inflows or outflows from
disposal of any items that are replaced such as their
salvage value or costs of dismantling and discarding.

2. Investments in receivables and inventories.

These are typically included as an outlay at time zero
and are assumed to be recouped at the end of the
project's life. The difference between the initial outlay
for working capital (mostly receivables and inventories)
and the present value of its recovery is the present
value of the cost of using working capital in the project.

3. Future disposal values. The disposal value at the

date of termination of a project is an increase in the
cash inflow in the year of disposal.

4. Operating cash flows. The major purpose of most

investments is to affect revenue or costs (or both). Only
overhead costs that differ between alternatives should
be included. Depreciation and book values should be
ignored. Finally, a reduction in a cash outflow is treated
the same as a cash inflow.

C. Cash Flows for Investments in Technology

In comparing the cash flows predicted for a computer

integrated manufacturing system (CIM) with the status quo,
the expected cash flows for the status quo manufacturing
system should be adjusted for probable decreases in market
share, and subsequently revenues, if others in the industry
are making CIM investments. Also, unanticipated cost
savings such as the flexibility to make product mix changes
easily and the ability to implement design changes quickly
and cheaply should be considered. Finally, the difficult-to-
predict revenue and cost effects of a CIM investment can be
incorporated in the investment decision subjectively.

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V. Income Taxes and Capital Budgeting {L. O. 5}
TEACHING TIP: Internet site see the following for tax resources:
http://www.taxsites.com/

Income taxes require cash disbursements. They can affect the

amount and timing of cash flows. One of their roles in capital
budgeting is to narrow the cash differences between projects. Cash
savings from operations (i.e., inflows) cause an increase in taxable
income, which creates partially offsetting increases in tax outflows.
For example, a 40% income tax rate would reduce a $1 million cash
operating savings to $600,000 because $400,000 of the $1 million
would be paid in taxes. Marginal Income Tax Rate - the tax rate
paid on additional pretax income. In capital budgeting, it is the
companys relevant tax rate that is applied to additional cash
inflows generated by a proposed project.

A. Effects of Depreciation Deductions

One item that often differs between tax reporting and public
reporting is depreciation. For public reporting purposes,
depreciation spreads the cost of an asset over its useful life.
Accelerated Depreciation - which charges a larger
proportion of an asset's cost to the earlier years and less to
later years for tax purposes.

See EXHIBIT 11-3 for an illustration of the interrelationships

of income before taxes, income taxes, depreciation, and cash
flows. The total after-tax effect on cash from an investment
can be determined several ways. In one calculation,
expenses other than depreciation are added to income taxes,
which are then deducted from sales to obtain the after-tax
cash. In another calculation, depreciation is added back to
net income to arrive at after-tax cash. In a third method of
computation, after-tax income, excluding the depreciation
effects, are computed. Then, the tax savings generated
because of the presence of depreciation are added to arrive at
the total after-tax effect on cash.

Recovery Period - period over which an asset is depreciated

for tax purposes. Depreciation of fixed assets creates future
tax deductions. The present value (PV) of the deductions
depends on their specific yearly effects on future income tax
payments. Therefore, the PV is influenced by the recovery

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period, the depreciation method used, the tax rates, and the
discount rate.

EXHIBIT 11-4 shows a method of analyzing data for capital

budgeting, assuming straight-line depreciation. This method
separates the cash effects of operations with the cash effects
of depreciation.

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B. Tax Deductions, Cash Effects, and Timing

The after-tax cash flows from revenues and expenses other

than depreciation are found by multiplying the pretax
amounts by (1 - the tax rate). In contrast, the after-tax effects
of noncash expenses (e.g., depreciation) are computed by
multiplying the tax deduction by the tax rate itself. Note that
this is treated as a cash inflow because it is a decrease in the
tax payment. The total cash effect of a noncash expense is
only the tax-savings effect.

Two assumptions are that tax payments occur concurrently

with related pretax cash flows and that the companies for
which analysis is desired are profitable. The first assumption
is fairly realistic since companies pay estimated taxes
throughout the year. The second assumption is necessary so
that the tax benefits can be realized.

C. Accelerated Depreciation

Income tax laws allow the use of accelerated depreciation

methods. Accelerated depreciation is any pattern of
depreciation that writes off depreciable assets more quickly
than does ordinary straight-line depreciation. The effect of
using an accelerated depreciation method on a capital
budgeting analysis is to increase the project's NPV. This is the
result of the tax savings occurring earlier in the life of the
project and the fact that early-period cash flows are
discounted less than late-period ones. See EXHIBIT 11-5 for
examples of assets in the eight MACRS classes. See EXHIBIT
11-6 for MACRS depreciation schedules for recovery periods
of 3, 5, 7, and 10 years.

D. Present Value of MACRS Depreciation

In capital-budgeting decisions it is often useful to know the PV

of the tax savings from depreciation. See EXHIBIT 11-7 for
the PVs for $1 to be depreciated over MACRS schedules for 3-,
5-, 7-, and 10-year recovery periods. The PV of tax savings
can be found in three steps.

1. Find the factor from EXHIBIT 11-7 for the appropriate

recovery period and the required return.
2. Multiply the factor by the tax rate to find the tax savings
per dollar of investment.

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3. Multiply the result by the amount of the investment to
find the total tax savings.

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 E. Gains or Losses on Disposal {L. O. 6}
The disposal of equipment for cash can also affect income
taxes. Gains are taxed, reducing the net cash inflow from the
sale of assets by the amount of the tax on the gain. Losses
create tax savings, which can be added to the cash proceeds
from the sale to obtain the net cash inflow from disposing of
an asset. While losses do result in tax savings and gains
result in additional taxes, a company still has more net cash
inflow from disposing of their assets when gains are realized.

VI. Confusion about Depreciation

The roles of depreciation and book value are widely misunderstood

when performing an analysis of the replacement of equipment. The
following points summarize the role of depreciation for this type of
decision (See EXHIBIT 11-8).

1. Initial investment: The amount paid for (and hence the

depreciation on) old equipment is irrelevant, except for its
effect on tax cash flows. However, the amount paid for new
equipment is relevant because it is an expected future cost
that will not be incurred if replacement is rejected.

2. Do not double-count: The investment in equipment is a one-

time outlay at time zero. It should not be double-counted as
an outlay in the form of depreciation.

3. Relation to income tax cash flows: The relevant item is the

income tax effect, not the book value or the depreciation.
The book value and depreciation are useful in predicting
future income tax disbursements.

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VII. Capital Budgeting and Inflation {L. O. 7}
In addition to taxes, capital-budgeting decision makers should
consider the effects of inflation on their cash flow predictions. If
significant inflation is expected over the life of a project, it should
be specifically and consistently analyzed in a capital-budgeting
model.

A. Watch for Consistency

Adjustments for inflation in both the minimum desired rate of

return and in the cash-flow predictions should be included in
an analysis. Nominal (or market) interest rates - quoted
market interest rate that includes an inflation element. If
used in a capital budgeting analysis, the cash flows should be
adjusted for inflation. See EXHIBIT 11-9 for the correct and
incorrect ways to analyze an investment when inflation is
present. Note that the recommended course of action differs
based on the two different NPVs that are calculated. If a real
rate of interest were used, the cash flows would not need to
be adjusted.

B. Role of Depreciation

Note that the cash savings from depreciation shown in

EXHIBIT 11-9 are not affected by inflation since the amount
of depreciation allowed by tax laws is based on an initial
outlay at time zero. Critics claim that not allowing inflation
adjustments for capital assets in computing annual
depreciation discourages investment, while defenders of the
existing U.S. tax laws assert that capital investment is
encouraged in many other ways such as the use of
accelerated depreciation methods.

C. Improvement of Predictions with Feedback

Auditing and feedback help to improve managers predictive

skills. In adjusting for inflation, managers should use specific
price indices rather than general ones in making their
predictions.

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VIII. Other Models for Analyzing Long-Range
Decisions {L. O. 8}
A. Payback Model

Payback Time (or Payback Period) - measure of time it will

take to recoup, in the form of cash inflows from operations,
the initial outlay. In formula form:

payback time = initial investment / equal annual cash

inflows from operations

A weakness is that it does not measure profitability (i.e., the

cash flows beyond the payback period). A strength is that it
provides a rough estimate of risk, especially in decisions
involving areas of rapid technological change. When uneven
cash flows are present, the formula given above cannot be
employed. Instead, a cumulative approach must be used.
Cash flows are accumulated until an amount equaling the
initial investment is obtained. Prorating cash flows in the last
year of the payback is sometimes required.

B. Accounting Rate-of-Return Model

Accounting Rate-Of-Return (ARR) Model (or the accrual

accounting rate-of-return model, the unadjusted rate-of-
return model, the book-value model) - a non-DCF capital-
budgeting model expressed as the increase in expected
average annual operating income divided by the initial
required investment.

ARR = increase in expected average annual operating income /

initial required
investment

It shows the effect of an investment on an organizations

financial statements. The ARR may also be computed using
the average investment in the asset, in which case the rate
doubles. Major weaknesses of the ARR model are that it
ignores the time value of money and the timing of cash flows.

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IX. Performance Evaluation {L. O. 9}
A. Potential Conflict

Managers are frequently frustrated if they are instructed to

use a DCF model for making decisions and are evaluated later
by a non-DCF model, such as the typical accounting rate-of-
return model, which is based on accounting income instead of
cash flows. An illustration is provided which shows that the
ARR can be low in the early years of an asset's life (due to a
high book value) and higher in later years. Unfortunately,
managers expecting to move to new positions within the next
few years will be reluctant to make equipment replacement
decisions because they will not be around when the higher
ARR figures occur. They are also reluctant to replace due to
heavy book losses on replaced equipment (see discussion in
CHAPTER 6).

B. Reconciliation of Conflict

Resolving the conflict between the use of DCF models for

decision making and non-DCF measures of performance can
be accomplished through the use of non-DCF models for
decision making. However, the DCF models are superior
analytical models. Another approach would be to use DCF
models for both decision making and performance evaluation.
Postaudits - a follow-up evaluation of capital-budgeting
decisions. The purposes of postaudits include:

1. Seeing that investment expenditures are proceeding on

time and within budget.

2. Comparing actual cash flows with those originally

predicted in order to motivate careful and honest
prediction.

3. Providing information for improving future predictions of

cash flows.

4. Evaluating the continuation of the project.

Postaudits are costly to perform because financial information

is usually collected, summarized, and reported for products,
departments, divisions, and territories, not for projects.

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However, most large companies use postaudits to some
degree.

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CHAPTER 11: TRANSPARENCY MASTERS
The following exhibits are reproduced as transparency masters at the end
of this manual:

Exhibit 11-1 Net-Present-Value Method

Exhibit 11-2 Total Project Versus Differential Approach to Net

Present Value

Exhibit 11-3 Martins Printing - Basic Analysis of Income

Statement, Income Taxes, and Cash Flows

Exhibit 11-4 Impact of Income Taxes on Capital-Budgeting

Analysis

Exhibit 11-5 Examples of Assets in Modified Accelerated Cost

Recovery System (MACRS) Classes

Exhibit 11-6 Selected MACRS Depreciation Schedules

Exhibit 11-7 Present Value of $1 of MACRS Depreciation

Exhibit 11-8 Perspective on Book Value and Depreciation

Exhibit 11-9 Inflation and Capital Budgeting

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CHAPTER 11: Quiz/Demonstration Exercises
Learning Objective 1

1. Accountants are usually involved in which phase(s) of capital

budgeting?

a. identifying potential investments

b. postaudits
c. choosing which investments to make
d. b and c
e. a, b, and c

Use the following information for questions 2 and 3.

Clare Company is considering the purchase of some labor-saving

equipment for its packaging department. The equipment is expected
to result in labor cost savings of $50,000 per year for the expected
five-year life of the equipment. The cost of the equipment is $120,000
and the desired rate of return is 6%.

2. The NPV of the investment for Clare Company is

a. $27,434 b. $55,000 c. $(27,434) d. $50,000

Learning Objective 2

3. By how much could the annual labor savings of the equipment

described in the illustration above decrease for the project to be
minimally acceptable?

a. None at all, it is just barely acceptable now.

b. None at all, it is below the acceptable point already.
c. Just over 15% of the present $30,000 per year labor savings.
d. Just over 18% of the present $30,000 per year labor savings.

4. Sensitivity analysis allows a manager to answer what if questions in

regard to changes in:

a. useful life
b. cash flows
c. risk
d. all of the above

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e. b and c

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Learning Objective 3

Use the following information for questions 5 and 6.

Adele Corporation (AC) is considering the replacement of some electric

generating equipment by a more efficient, technologically advanced
model. The new equipment costs $110,000, but the vendor has
agreed to provide a trade-in on the existing equipment of $35,000.
The present equipment has a remaining useful life of four years and
the new equipment would also be retired at the end of its fourth year
of service. Given the expected level of future operations, the existing
generating equipments operating costs are predicted to run $40,000
per year. The new equipment is expected to result in operating costs
of $20,000 per year. The current equipment would have a $40,000
salvage value at the end of its useful life, while the proposed
equipment's salvage value is estimated to be $20,000. AC's minimum
desired rate of return on investments is 10%.

5. In using the total project approach, the NPV of retaining the existing
equipment is

a. ($108,888) b. ($99,476) c. ($113,136) d. some

other amount.

6. The NPV difference between the two projects using the differential
approach is

a. $0.
b. $9,413 in favor of replacing the generating equipment.
c. $9,413 in favor of keeping the present equipment.
d. some other amount.

Learning Objective 4

7. When analyzing relevant cash flows for NPV, the following should be
considered:

a. initial cash inflows and outflows at time zero

b. investments in receivables and inventories
c. fixed overhead
d. none of the above
e. a and b

8. An error that is usually not crucial in NPV is a miscalculation in the:

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a. operating cash flows
b. disposal value
c. initial cash inflows
d. none of the above

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Learning Objective 5

Use the following information for questions 9 through 13.

Joshua Manufacturing Company (JMC) is considering buying some new

equipment that would allow for increased sales of its product. The
incremental impact of the proposed $280,000 investment is shown
below using straight-line depreciation and an expected useful life of
four years for the equipment. The company has a minimum desired
rate of return of 14%.

Revenues $420,000
Non-depreciation expenses $240,000
Depreciation 70,000
Total expenses $310,000
Taxable income $110,000
Income tax (40%) 44,000
Net Income $ 66,000

9. The annual cash inflows expected from the project are

a. $80,000 b. $68,000 c. $136,000 d. $108,000

10. The present value of the tax savings from straight-line depreciation is

a. $100,000 b. $81,584 c. $28,274 d. $0

11. The NPV of the investment using straight-line depreciation is

a. ($280,000) b. ($1,868.40) c. $396,264 d.

$116,264.

12. If the investment were allowed to be depreciated over a three-year

recovery period and the double-declining-balance method of
depreciation were used, the present value of the tax savings from
depreciation would be

a. $58,274 b. $66,464 c. $93,050 d. $280,000.

13. Using the DDB depreciation and a three-year recovery period to

compute the tax savings from depreciation results in

a. an NPV that would suggest that the investment should be made.

b. a higher NPV, and is still positive to make the investment

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 desirable.
c. an even lower NPV of the investment than resulted using the
straight-line method.
d. the same NPV as was computed when using straight-line
depreciation.

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Learning Objective 6

Use the following information for questions 14 and 15.

Donald T. Corporation is considering the replacement of a piece of

equipment that it bought three years ago for $75,000. At the time of
purchase, the equipment was expected to have a useful life of five
years. Donald T., whose tax rate is 30%, uses straight-line
depreciation.

14. If Donald T. is able to sell the equipment for $55,000, the net cash
flows from the sale are

a. $20,000 b. $75,000 c. $47,500 d. $40,500

15. If Donald T. is able to sell the equipment for $25,000, the net cash
flows from the sale are

a. $5,000 b. $26,500 c. $19,500 d. $30,000

16. Depreciation affects capital budgeting decisions by

a. creating tax savings in the amount of the tax rate multiplied by

the depreciation claimed.
b. reducing cash flows provided by projects.
c. increasing cash flows by a dollar for each dollar of depreciation
claimed.
d. creating tax savings in the amount of the annual depreciation.

Learning Objective 7

17. If a market interest rate, which includes an inflation component, is

used by a company as its minimum required rate of return in a net
present value analysis

a. the expected cash flows from operations must not be adjusted

for inflation in order for the analysis to be consistent.
b. the expected cash flows from operations must be adjusted for
inflation in order for the analysis to be consistent.
c. the project will automatically be unacceptable.
d. the expected tax savings from depreciation must be adjusted for
inflation in order for the analysis to be consistent.

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18. If a real interest rate, which does not include an inflation component,
is used by a company as its minimum required rate of return in a net
present value analysis

a. the project will automatically be unacceptable.

b. the expected cash flows from operations must be adjusted for
inflation in order for the analysis to be consistent.
c. the expected tax savings from depreciation must be adjusted for
inflation in order for the analysis to be consistent.
d. the expected cash flows from operations must not be adjusted
for inflation in order for the analysis to be consistent.

Learning Objective 8

19. The payback model and the accounting rate-of-return model

a. are alternative models that may be used in making capital-

budgeting decisions that ignore the time value of money.
b. are impossible to apply, and therefore are never used.
c. are two excellent DCF models.
d. are never used because they are just too simple.

20. A possible solution to the problem of reconciling the conflict between

making decisions using a DCF model and using accounting income for
measuring the resulting performance

a. is to make decisions with accounting-based decision models

such as the accounting rate-of-return in the first place.
b. is to conduct postaudits to compare actual with predicted cash
flows for the DCF models rather than basing evaluations of
projects on accounting measures.
c. is to not use either method.
d. is to do either a. or b.

Learning Objective 9

21. DCF models may influence managers to make decisions that only
benefit the:

a. short-run time period

b. long-run time period
c. both a and b
d. neither a nor b

230
22. The purposes of a postaudit do not include:

a. seeing that investment decisions are proceeding on time

b. comparing actual cash flows with predicted cash flows
c. providing information for improving prior predictions of cash
flows
d. evaluating the continuation of the project

231
CHAPTER 11: Solutions to Quiz/Demonstration
Exercises

1. [d]

2. [a] The NPV is found by subtracting the initial investment

required from the present value of the future cash inflows. In
this case, $35,000 annual cash inflow x 4.2124 (the interest
factor from Table 2 for 5 years at 6%) = $147,434. $147,434 -
$120,000 = $27,434.

3. [c] The level of annual cash inflows that makes the packaging
equipment investment minimally acceptable is $28,487.32. This
can be found by dividing the required present value of the cash
inflows to make the project minimally acceptable (NPV = $0) of
$120,000 by the Table 2 annuity present-value factor of 4.2124.
The reduction of $6,512.68 is just over 18% of the initial $35,000
annual savings.

4. [d]

5. [c] The computations for each alternative using the total

project approach are

Item PV factor P Value Period 0 Period 1 Period 2 Period 3

Period 4
KEEP
Operating Costs 3.1699 ($126,796) ($40,000) ($40,000)
($40,000) ($40,000) Salvage Value .6830 $ 27,320
$40,000
NPV ($ 99,476)

Item PV factor P Value Period 0 Period 1 Period 2 Period

3 Period 4
REPLACE
Net Initial Outlay 1.0000 ($75,000) ($75,000)
Operating Costs 3.1699 ($47,548) ($15,000) ($15,000)
($15,000) ($15,000)
Salvage Value .6830 $13,660
$20,000
NPV ($108,888)

232
6. [b] Using the differential approach, from the KEEP
perspective the NPV analysis is

Item PV factor P Value Period 0 Period 1 Period 2 Period 3

Period 4
Net Initial Outlay 1.0000 $75,000 $75,000
Operating Costs 3.1699 ($79,247) ($25,000) ($25,000)
($25,000) ($25,000)
Salvage Value .6830 ($13,660)
$20,000
NPV ($ 9,413)

7. [e] 8. [b]

9. [c] The easiest way to compute the cash flows generated by

the investment is to add the depreciation back to the net
income. In this case, $70,000 + $68,000 = $136,000.
Alternatively, one could add the after-tax cash flows from
operations to the tax savings resulting from the depreciation
expense. Here, $108,000 [($420,000 - $240,000) x (1 - .40)] +
$28,000 [$70,000 x .40] also gives $136,000 in total after-tax
cash flows.

10. [b] The annual tax savings from depreciation are $28,000 [$70,000 x
.40]. The present value of the savings is computed by
multiplying the $28,000 by the present value factor for an
annuity for four years at 14% of 2.9137. The result is $81,584.

11. [d] The computations are shown below. The after-tax cash flows
from operations are $108,000 per year [($420,000 - $240,000) x
(1 - .60)], while the annual tax savings from depreciation are
given above.

Item PV factor PV Period 0 Period 1 Period 2

Period 3 Period 4
After-tax operating cash
flow increase 2.9137 $314,680 $108,000 $108,000
$108,000 $108,000
Depreciation tax savings 2.9137 81,584 $28,000 $28,000

233
$28,000 $28,000
Initial investment 1.0000 ($280,000) ($280,000)
Net Present Value $116,264

12. [c] The savings from depreciation using DDB and a three year life
can be found by multiplying the investment amount by the
present value factor and then multiplying the resulting amount
by the tax rate ($280,000 x .8308 x .40 = $93,050).

13. [b] Using the data from questions 11 and 13 above, the NPV would
be $127,730, which makes the investment even more
acceptable. The $127,730 can be found by adding the difference
in the tax savings from depreciation, $11,466 [$93,050 -
$81,584], to the NPV found using straight-line depreciation,
$116,264. Point out to students that the use of the accelerated
depreciation method changes the decision.

234
14. [c] The $55,000 from the sale must be reduced by the $7,500 tax on
the gain from selling the equipment. The book value was
$30,000 [$75,000 - (3 x $15,000/yr.)] resulting in a gain of
$25,000. $25,000 x .30 = $7,500 of tax on the gain.

15. [b] The $25,000 from the sale must be increased by the tax savings
created by the loss from selling the equipment. The loss of
$5,000 [$30,000 book value - $25,000 selling price] results in a
$1,500 [$5,000 x .30] tax savings creating total cash flows of
$26,500.

16. [a] 17. [b] 18. [d] 19. [a] 20. [c] 21. [a] 22. [c]

235
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