Chapter 12: The Capital Budgeting Decision
Chapter 12
The Capital Budgeting Decision
Discussion Questions
12-1.
What are the important administrative considerations in the capital budgeting
process?
12-2.
Why does capital budgeting rely on analysis of cash flows rather than on net
income?
12-3.
What are the weaknesses of the payback method?
12-4.
What is normally used as the discount rate in the net present value method?
12-5.
What does the term mutually exclusive investments mean?
12-6.
How does the modified internal rate of return include concepts from both the
traditional internal rate of return and the net present value methods?
Chapter 12: The Capital Budgeting Decision
12-7.
If a corporation has projects that will earn more than the cost of capital, should
it ration capital?
12-8.
What is the net present value profile? What three points should be determined
to graph the profile?
12-9.
How does an asset’s ADR (asset depreciation range) relate to its MACRS
category?
Chapter 12
Problems
1. Cash flow (LO12-2) Assume a corporation has earnings before depreciation and taxes of
$90,000, depreciation of $40,000, and a 30 percent tax bracket. Compute its cash flow using the
following format:
Earnings before depreciation and taxes _____
Chapter 12: The Capital Budgeting Decision
Earnings before depreciation and taxes $90,000
Depreciation –40,000
Earnings before taxes 50,000
Taxes @ 30% –15,000
Earnings after taxes $35,000
Depreciation +40,000
Cash flow $75,000
2. Cash flow (LO12-2) Assume a corporation has earnings before depreciation and
taxes of $100,000, depreciation of $40,000, and that it has a 40 percent tax bracket.
a. Compute its cash flow using the following format:
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 40% _____
Earnings after taxes _____
Depreciation _____
b. Compute the cash flow for the company if depreciation is only $20,000.
c How much cash flow is lost due to the reduced depreciation from $40,000 to
$20,000?
a. Earnings before depreciation and taxes $100,000
Depreciation – 40,000
Earnings before taxes 60,000
Chapter 12: The Capital Budgeting Decision
Taxes @ 40% 24,000
Earnings after taxes 36,000
Depreciation + 40,000
Cash flow $ 76,000
12-3. Solution:
a. Earnings before depreciation and taxes $200,000
Depreciation – 0
Earnings before taxes 200,000
Taxes @ 40% – 80,000
Earnings after taxes 120,000
Chapter 12: The Capital Budgeting Decision
Depreciation – 0
Cash flow $120,000
12-4. Solution:
a. Earnings before depreciation and taxes $440,000
Depreciation 140,000
Earnings before taxes 300,000
Taxes @ 35% 105,000
Earnings after taxes 195,000
Chapter 12: The Capital Budgeting Decision
5. Cash flow versus earnings (LO12-2) Al Quick, the president of a New York Stock
Exchange —listed firm, is very short-term oriented and interested in the immediate
consequences of his decisions. Assume a project that will provide an increase of $2 million
in cash flow because of favorable tax consequences, but carries a two-cent decline in
earnings per share because of a write-off against first-quarter earnings. What decision
might Mr. Quick make?
12-5. Solution:
Al Quick
6. Payback method (LO12-3) Assume a $250,000 investment and the following cash flows
for two products:
Year
Product X
Product Y
1
$90,000
$50,000
2
90,000
80,000
3
60,000
60,000
4
20,000
70,000
Which alternatives would you select under the payback method?
12-6. Solution:
Chapter 12: The Capital Budgeting Decision
Payback for Product X Payback for Product Y
7. Payback method (LO12-3) Assume a $40,000 investment and the following cash flows for
two alternatives.
Year
Investment X
Investment Y
1
$ 6,000
$15,000
2
8,000
20,000
3
9,000
10,000
4
17,000
—
5
20,000
—
Which of the alternatives would you select under the payback method?
12-7. Solution:
Payback for Investment X Payback for Investment Y
$40,000–$6,000 1 year $40,000–$15,000 1 year
34,000–8,000 2 years 25,000–20,000 2 years
Chapter 12: The Capital Budgeting Decision
5 .................
25,000
—
a. Calculate the payback for investment A and B.
b. If the inflow in the fifth year for Investment A was $25,000,000 instead of $25,000,
would your answer change under the payback method?
a. Payback for Investment A Payback for Investment B
$90,000 – $25,000 1 year $90,000 – $40,000 1 year
65,000 – 30,000 2 years 50,000 – 40,000 2 years
35,000 – 25,000 3 years 10,000/28,000 .36 years
10,000/19,000 0.53 years
Payback Investment A = 3.53 years
Payback Investment B = 2.36 years
Investment B would be selected because of the faster payback.
b. The $25,000,000 inflow would still leave the payback period for
Investment A at 3.53 years. It would remain inferior to Investment
B under the payback method.
Chapter 12: The Capital Budgeting Decision
4–10.............
10,000
10,000
a. Using the payback method, what will the decision be?
12-9. Solution:
Short-Line Railroad
a.
Payback for Electric Co. Payback for Water Works
$140,000 – $85,000 1 year $140,000 – $30,000 1 year
55,000 – 25,000 2 years 110,000 – 25,000 2 years
30,000 – 30,000 3 years 85,000 – 85,000 3 years
Chapter 12: The Capital Budgeting Decision
3 ....................
6,000
16,000
12-10. Solution:
X-treme Vitamin Company
a. Payback Method
Payback for Project A
10,000 .83 years
12,000 =
Payback for Project B
10,000 1 year
10,000 =
Chapter 12: The Capital Budgeting Decision
Year Cash Flow PVIFA Present Value
1 $10,000 .909 $ 9,090
2 $ 6,000 .826 $ 4,956
3 $16,000 .751 $12,016
Present value of inflows $26,062
Present value of outflows 10,000
Net present value $16,062
Under the net present value method, you should select
Project B because of the higher net present value.
c. A company should normally have more confidence in answer
b because the net present value considers all inflows as well
as the time value of money. The heavy late inflow for Project
B was partially ignored under the payback method.
Calculator Solution:
(b-1)
Project A using a financial calculator:
Use the NPV keys by pressing and entering the following:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 10,000 +|– key, press the Enter key.
Press down arrow, enter 12,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 8,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 6,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press NPV; calculator shows I = 0; enter 10 and press Enter.
Chapter 12: The Capital Budgeting Decision
11. Internal rate of return (LO12-4) You buy a new piece of equipment for $16,230, and you
receive a cash inflow of $2,500 per year for 12 years. What is the internal rate of return?
Appendix D
IFA $16,230
$2,500
==
IRR = 11%
For n = 12, we find 6.492 under the 11% column.
Calculator Solution:
Using a financial calculator,
12. Internal rate of return (LO12-4) King’s Department Store is contemplating the purchase
Chapter 12: The Capital Budgeting Decision
King’s Department Store
Appendix D
PVIFA = $22,802/$3,500 = 6.515
IRR = 7%
For n = 9, we find 6.515 under the 7% column.
The machine should not be purchased since its return is less
than the 10 percent cost of capital.
Calculator Solution:
(a)
3 .........................
18,000
a. Determine the internal rate of return.
b. With a cost of capital of 18 percent, should the machine be purchased?
Home Security Systems
Chapter 12: The Capital Budgeting Decision
a. Step 1 Average the inflows.
$25,000
23,000
18,000
$66,000 / 3 $22, 000=
Step 2 Divide the inflows by the assumed annuity in Step 1.
Investment $50,000 2.273
Annuity 22,000
==
Chapter 12: The Capital Budgeting Decision
12-13. (Continued)
Year Cash Flow PVIF at 17% Present Value
–49,420 ........... PV @ 17% –50,000............. Cost
$ 757 $ 177
16% + ($177/$757) (1%)
14% + .234 (1%) = 16.23% IRR
The IRR is 16.23%
Chapter 12: The Capital Budgeting Decision
$50,177 ........... PV @ 16% $50,177............. PV @ 16%
$ 1,526 $ 177
16% + ($177/$1,526) (2%)
16% + (.12)(2%) = 16.24%
This answer is very close to the previous answer, the
difference is due to rounding and that the differences
between the numbers in the table are not linear.
b. Since the IRR of 16.23 percent (or 16.24 percent) is less than
the cost of capital of 18 percent, the project should not be
accepted.
Calculator Solution:
Alternatively, use a financial calculator as follows to obtain the correct answer rather than
an approximation.
Press the following keys: 2nd, CF, 2nd, Clear.
14. Net present value method (LO12-4) Aerospace Dynamics will invest $110,000 in a
project that will produce the following cash flows. The cost of capital is 11 percent. Should
the project be undertaken? (Note that the fourth year’s cash flow is negative.)
Chapter 12: The Capital Budgeting Decision
Aerospace Dynamics
Year Cash Flow PVIF at 11% Present Value
1 $36,000 .901 $ 32,436
2 44,000 .812 35,728
3 38,000 .731 27,778
4 (44,000) .659 (28,996)
5 81,000 .593 48,033
Present Value of Inflows $114,979
Present Value of Outflows 110,000
Net Present Value $ 4,979
The net present value is positive and the project should be
undertaken.
Calculator Solution:
Using a financial calculator,
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 110,000 +|– key, press Enter.
Press down arrow, enter 36,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 44,000, and press Enter.
Chapter 12: The Capital Budgeting Decision
3.................
40,000
The firm will also be required to spend $10,000 to close down the project at the end of the
three years. If the cost of capital is 10 percent, should the investment be undertaken?
12-15. Solution:
Horizon Company
Present Value of Inflows
Year Cash Flow × PVIF at 10% Present Value
1 $15,000 .909 $13,635
2 25,000 .826 20,650
3 40,000 .751 30,040
$64,325
Chapter 12: The Capital Budgeting Decision
Note, the $10,000 outflow could have been subtracted out of
the $40,000 inflow in the third year and the same answer
would result.
Calculator Solution:
Using a financial calculator,
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 60,000 +|– key, press the Enter key
Press down arrow, enter 15,000, and press Enter.
16. Net present value method (LO12-4) Skyline Corp. will invest $130,000 in a project that
will not begin to produce returns until after the 3rd year. From the end of the 3rd year until
the end of the 12th year (10 periods), the annual cash flow will be $34,000. If the cost of
capital is 12 percent, should this project be undertaken?
Skyline Corporation
Present Value of Inflows
Find the present value of a deferred annuity
A = $34,000, n = 10, i = 12%
PVA = A × PVIFA (Appendix D)
PVA = $34,000 × 5.650 = $192,100
Chapter 12: The Capital Budgeting Decision
Discount from beginning of the third period (end of second
period to present):
FV = $192,100, n = 2, i = 12%
PV = FV × PVIF (Appendix B)
PV = $192,100 × .797 = $153,104
Present Value of Inflows $153,104
Present Value of Outflows 130,000
Net Present Value $ 23,104
The net present value is positive and the project should be
undertaken.
Calculator Solution:
Using a financial calculator,
Press the following keys: 2nd, CF, 2nd, Clear.
3 .................
4,000
a. What is the net present value at an 8 percent discount rate?
Chapter 12: The Capital Budgeting Decision
12-17. Solution:
Hudson Corporation
a. Net Present Value
Year Cash Flow × 8% PVIF Present Value
1 $13,000 .926 $ 12,038
2 13,000 .857 11,141
3 4,000 .794 3,176
12-17. (Continued)
We divide the investment by the assumed annuity value.
IFA
$24,000 2.400 PV
10,000 =
Using Appendix D for n = 3, the first approximation appears
to fall between 12 percent and 14 percent. Since the heavy
inflows are in the early years, we will try 14 percent.
Chapter 12: The Capital Budgeting Decision
Year Cash Flow × 14% PVIF Present Value
1 $13,000 .877 $ 11,401
2 13,000 .769 9,997
3 4,000 .675 2,700
Present Value of Inflows $24,098
Since 14 percent is not high enough to get $24,000 as the
present value, we will try 16 percent. (We could have only
gone up to 15 percent, but we wanted to be sure to include
$24,000 in this calculation. Of course, students who use 15
percent are doing fine.)
Chapter 12: The Capital Budgeting Decision
The correct answer falls between 14 percent and 15 percent.
We interpolate.
$24,098 PV @ 14% $24,098 PV @ 14%
23,770 PV @ 15% 24,000 Cost
328 $ 98
$98
14% (1%) 14% .30 (1%) 14% .30% 14.30%
$328
+ = + = + =
c. Yes. Both the NPV is greater than 0 and the IRR is greater
than the cost of capital.
Calculator Solution:
(a)
Press the following keys: 2nd, CF, 2nd, and Clear.
Calculator displays CFo, 24,000 +|– key, press Enter.
Press down arrow, enter 13,000, and press Enter.
Press down arrow, enter 2, and press Enter.
Press down arrow, enter 4,000, and press Enter.
Press down arrow, enter 1, and press Enter.
18. Net present value and internal rate of return methods (LO12-4) The Pan American
Bottling Co. is considering the purchase of a new machine that would increase the speed of
Chapter 12: The Capital Budgeting Decision
5 ...........
8,000
12-18. Solution:
Pan American Bottling Co.
a. Net Present Value
Year Cash Flow × 13% PVIF Present Value
12-18. (Continued)
b. Internal Rate of Return
We will average the inflows to arrive at an assumed annuity.
$23,000
26,000
Chapter 12: The Capital Budgeting Decision
29,000
15,000
8,000
$101,000/5 = $20,200
We divide the investment by the assumed annuity value.
IFA
$60,000 2.97 PV
$20,200 =
Chapter 12: The Capital Budgeting Decision
12-18. (Continued)
The correct answer must fall between 20 and 25 percent. We
interpolate.
$64,440 ........... PV @ 20% $64,440............. PV @ 20%
58,662 ............ PV @ 25% 60,000............. Cost
$ 5,778 $ 4,440
$4,440
20% (5%) 20% .77 (5%) 20% 3.85% 23.85%
$5,778
+ = + = + =
c. The project should be accepted because the net present value
is positive and the IRR exceeds the cost of capital.
Calculator Solution:
Find the NPV using a financial calculator:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 60,000 +|– key, press Enter.
Press down arrow, enter 23,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 26,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 29,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Chapter 12: The Capital Budgeting Decision
19. Use of profitability index (LO12-4) You are asked to evaluate the following two projects
for the Norton Corporation. Using the net present value method combined with the
profitability index approach described in footnote 2 of this chapter, which project would
you select? Use a discount rate of 14 percent.
Chapter 12: The Capital Budgeting Decision
12-19. Solution:
Norton Corporation
NPV for Project X
Year Cash Flow × PVIF at 14% Present Value
1 $10,000 .877 $ 8,770
2 8,000 .769 6,152
3 9,000 .675 6,075
4 8,600 .592 5,091
Present Value of Inflows $26,088
Present Value of Outflows (Cost) –20,000
Net Present Value $ 6,088
Chapter 12: The Capital Budgeting Decision
Present value of inflows
Profitability index ( ) Present value of outflows
$46,459 1.16
$40,000
Y=
==
You should select Project X because it has the higher
profitability index. This is true in spite of the fact that it has a
lower net present value. The profitability index may be
appropriate when you have different size investments.
Calculator Solution:
(a)
Find NPV using a financial calculator:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 20,000 +|– key, press the Enter key.
Press down arrow, enter 10,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 8,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 9,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 8,600, and press Enter.
Press down arrow, enter 1, and press Enter.
Press NPV; the calculator shows I = 0; enter 14 and press Enter.
Press down arrow; calculator shows NPV = 0.00.
Press CPT; calculator shows NPV = 6,094.30, which is the net present value of Project X.
Profitability index using a financial calculator:
Profitability Index = Present Value of Inflows / Present Value of Outflows
Present Value of Inflows = NPV + Outflows
Chapter 12: The Capital Budgeting Decision
5 .................
29,000
The internal rate of return is 11 percent.
Turner Video
a. Reinvestment assumption of NPV
No. of Future
Year Inflows Rate Periods Value Factor Value
1 $15,000 12% 4 1.574 $23,610
2 17,000 12% 3 1.405 23,885
Chapter 12: The Capital Budgeting Decision
3 21,000 12% 2 1.254 26,334
4 25,000 12% 1 1.120 28,000
5 29,000 – 0 1.000 29,000
$130,829
b. Reinvestment assumption of IRR
No. of Future
Year Inflows Rate Periods Value Factor Value
1 $15,000 11% 4 1.518 $ 22,770
2 17,000 11% 3 1.368 23,256
3 21,000 11% 2 1.232 25,872
4 25,000 11% 1 1.110 27,750
5 29,000 – 0 1.000 29,000
$128,648
c. No. However, for investments with a very high IRR, it may
be unrealistic to assume that reinvestment can take place at
an equally high rate. The net present value method makes the
more conservative assumption of reinvestment at the cost of
capital.
(a)
Calculator Solution:
Find PV of cash inflow using a financial calculator at 12 percent:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 0, press the Enter key.
Press down arrow, enter 15,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 17,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 21,000, and press Enter.
Chapter 12: The Capital Budgeting Decision
3 ............
9,000
Chapter 12: The Capital Budgeting Decision
12-21. Solution:
Caffeine Coffee Company
Terminal Value (end of year 3)
a. FV Factor
Period of (11%) Future
Growth (Appendix A) Value
Year 1 $12,000 2 1.232 $14,784
Year 2 11,000 1 1.110 12,210
Year 3 9,000 0 1.000 9,000
Terminal Value $35,994
To determine the modified internal rate of return, calculate
the yield on the investment.
IF PV
PV (Appendix B)
FV
$26,000
= .722
35,994
==
=
Use Appendix B for three periods, the answer is
approximately 11 percent (.731).
b. The answer is lower than 17.5 percent under the Modified
IRR because inflows are reinvested at the cost of capital of
11 percent. Under the traditional IRR, inflows are reinvested
at the internal rate of return of 17.5 percent, which leads to
a higher terminal value.
Calculator Solution:
Chapter 12: The Capital Budgeting Decision
Using a financial calculator:
Find the PV of cash inflow using a financial calculator at 11 percent:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, 0, press the Enter key.
Press down arrow, enter 12,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 11,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 9,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press NPV; calculator shows I = 0; enter 11 and press Enter.
Press down arrow; calculator shows NPV = 0.00.
Press CPT; calculator shows NPV = 26,319.38, which is the present value of the inflow.
Next find the FV of the 26,319.38 as of year 3 at an 11 percent annual rate.
(a)
N
I/Y
PV
PMT
FV
3
11
26,319.38
0
CPT FV 35,995.20
3
CPT I I/Y 11.45
26,000
0
–35,995.20
22. Capital rationing and mutually exclusive investments (LO12-4) The Suboptimal Glass
Company uses a process of capital rationing in its decision making. The firm’s cost of
capital is 10 percent. It will only invest $77,000 this year. It has determined the internal
rate of return for each of the following projects.
Project
Project Size
Internal Rate of
Return
A .....................
$10,500
21%
B .....................
30,500
22
C .....................
25,500
18
D .....................
10,500
13
E .....................
10,500
20
F ......................
20,500
11
G .....................
10,500
16
a. Select the projects that the firm should accept.
Chapter 12: The Capital Budgeting Decision
b. If Projects A and B are mutually exclusive, how would that affect your overall
answer? That is, which projects would you accept in spending the $77,000?
12-22. Solution:
Suboptimal Glass Company
You should rank the investments in terms of IRR.
Project IRR Project Size Total Budget
B 22% $30,500 $ 30,500
A 21 10,500 41,000
E 20 10,500 51,500
C 18 25,500 77,000
23. Net present value profile (LO12-4) Keller Construction is considering two new
investments. Project E calls for the purchase of earthmoving equipment. Project H
represents an investment in a hydraulic lift. Keller wishes to use a net present value profile
in comparing the projects. The investment and cash flow patterns are as follows:
Chapter 12: The Capital Budgeting Decision
4 ...........................
10,000
a. Determine the net present value of the projects based on a zero discount rate.
b. Determine the net present value of the projects based on a 9 percent discount rate.
c. The internal rate of return on Project E is 13.25 percent, and the internal rate of return
Keller Construction Company
a. Zero discount rate
Project E
Inflows Outflow
8,000 = ($5,000 + $6,000 + $7,000 + $10,000) – $20,000
Project H
Inflows Outflow
$ 5,000 = ($16,000 + $5,000 + $4,000) – $20,000
Chapter 12: The Capital Budgeting Decision
b. 9 percent discount rate
Project E
12-23. (Continued)
Project H
Year Cash Flow PVIF at 9% Present Value
Chapter 12: The Capital Budgeting Decision
c. Net Present Value Profile
d. Since the projects are not mutually exclusive, they both can
be selected if they have a positive net present value. At a 9
percent cost of capital, they should both be accepted. As a
side note, we can see Project E is superior to Project H.
e. With mutually exclusive projects, only one can be accepted.
Of course, that project must still have a positive net present
value. Based on the visual evidence, we see:
(i) 6 percent cost of capital—select Project E
(ii) 13 percent cost of capital—select Project H
(iii) Do not select either project
Calculator Solution:
(b)
Using a financial calculator:
Project E:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, press 20,000 +|–, press the Enter key.
Press down arrow, enter 5,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 6,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 7,000, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 10,000, and press Enter.
Chapter 12: The Capital Budgeting Decision
3 .................
12,000
You are going to use the net present value profile to approximate the value for the internal
rate of return. Please follow these steps:
a. Determine the net present value of the project based on a zero discount rate.
Davis Chili Company
a. NPV @ 0% discount rate
Inflows Outflow
$8,000 = ($16,000 + $15,000 + $12,000) – $35,000
b.
Year Cash Flow PVIF at 10% Present Value
1 $16,000 .909 $ 14,544
Chapter 12: The Capital Budgeting Decision
2 15,000 .826 12,390
3 12,000 .751 9,012
Present Value of Inflows $35,946
Present Value of Outflows 35,000
Net Present Value $ 946
c.
Year Cash Flow PVIF at 15% Present Value
1 $16,000 .870 $ 13,920
2 15,000 .756 11,340
3 12,000 .658 7,896
Present Value of Inflows $33,156
Present Value of Outflows 35,000
Net Present Value ($ 1,844)
d. Net Present Value Profile
Calculator Solution:
Chapter 12: The Capital Budgeting Decision
(b)
25. MACRS depreciation and cash flow (LO12-2) Telstar Communications is going to
purchase an asset for $380,000 that will produce $180,000 per year for the next four years
in earnings before depreciation and taxes. The asset will be depreciated using the three-year
MACRS depreciation schedule in Table 12-12. (This represents four years of depreciation
based on the half-year convention.) The firm is in a 35 percent tax bracket. Fill in the
schedule below for the next four years.
Chapter 12: The Capital Budgeting Decision
12-25. Solution:
Telstar Communications Corporation
First, determine annual depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $380,000 .333 $ 126,540
2 380,000 .445 169,100
3 380,000 .148 56,240
4 380,000 .074 28,120
$380,000
Chapter 12: The Capital Budgeting Decision
26. MACRS depreciation categories (LO12-4) Assume $65,000 is going to be invested in
12-26. Solution:
a. Office furniture – Based on Table 12-8, this falls under
7-year MACRS depreciation. Then, examining Table 12-9,
the first year depreciation rate is .143. Thus:
$65,000 .143 $9,295=
b. Automobile – This falls under 5-year MACRS depreciation.
This first year depreciation rate is .200.
Chapter 12: The Capital Budgeting Decision
Year 4 ................... 40,000
The firm is in a 35 percent tax bracket and has an 8 percent cost of capital. Should it
purchase the asset? Use the net present value method.
12-27. Solution:
Summit Petroleum Corporation
First, determine annual depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $160,000 .333 $53,280
2 160,000 .445 71,200
3 160,000 .148 23,680
Chapter 12: The Capital Budgeting Decision
12-27. (Continued)
Then, determine the net present value.
Cash Flow Present
Year (inflows) PVIF at 8% Value
1 $64,148 .926 $59,401
2 80,170 .857 68,706
3 35,588 .794 28,257
4 30,144 .735 22,156
Present Value of Inflows $178,520
Present Value of Outflows 160,000
Net Present Value $ 18,520
The asset should be purchased based on the net present value.
Calculator Solution:
Chapter 12: The Capital Budgeting Decision
Year 6 ...................... 32,000
The firm is in a 30 percent tax bracket and has a 14 percent cost of capital. Should
Oregon Forest Products purchase the equipment? Use the net present value method.
Oregon Forest Products
First, determine annual depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $300,000 .200 $ 60,000
2 300,000 .320 96,000
3 300,000 .192 57,600
4 300,000 .115 34,500
5 300,000 .115 34,500
6 300,000 .058 17,400
$300,000
Chapter 12: The Capital Budgeting Decision
12-28. (Continued)
Then, determine the annual cash flow.
Annual Cash Flow
1 2 3 4 5 6
EBDT $112,000 $105,000 $82,000 $53,000 $37,000 $32,000
– D 60,000 96,000 57,600 34,500 34,500 17,400
EBT 52,000 9,000 24,400 18,500 2,500 14,600
T (30%) 15,600 2,700 7,320 5,550 750 4,380
EAT 36,400 6,300 17,080 12,950 1,750 10,220
+ D 60,000 96,000 57,600 34,500 34,500 17,400
Cash Flow $ 96,400 $102,300 $74,680 $47,450 $36,250 $27,620
Then, determine the net present value.
Cash Flow Present
Year (Inflows) PVIF @ 14% Value
1 $ 96,400 .877 $ 84,543
2 102,300 .769 78,669
3 74,680 .675 50,409
4 47,450 .592 28,090
5 36,250 .519 18,814
6 27,620 .456 12,595
Chapter 12: The Capital Budgeting Decision
29. MACRS depreciation and net present value (LO12-4) Universal Electronics is considering
the purchase of manufacturing equipment with a 10-year midpoint in its asset depreciation
range (ADR). Carefully refer to Table 12-11 to determine in what depreciation category the
asset falls. (Hint: It is not 10 years.) The asset will cost $120,000, and it will produce earnings
before depreciation and taxes of $37,000 per year for three years, and then $19,000 a year for
seven more years. The firm has a tax rate of 40 percent. With a cost of capital of 12 percent,
Because the manufacturing equipment has a 10-year midpoint
of its asset depreciation range (ADR), it falls into the 7-year
MACRS category as indicated in Table 12-8. Furthermore, we
see that most types of manufacturing equipment fall into the 7-
year MACRS category.
With seven-year MACRS depreciation, the asset will be
depreciated over eight years (based on the half-year
convention). Also, we observe that the equipment will produce
earnings for 10 years, so in the last 2 years there will be no
depreciation write-off.
We first determine the annual depreciation.
Chapter 12: The Capital Budgeting Decision
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
Chapter 12: The Capital Budgeting Decision
12-29. (Continued)
Annual Cash Flow
1
2
3
4
5
6
7
8
9
10
EBDT
$37,000
$37,000
$37,000
$19,000
$19,000
$19,000
$19,000
$19,000
$19,000
$19,000
Chapter 12: The Capital Budgeting Decision
12-29. (Continued)
Next, determine the net present value.
Cash Flow Present
Year (Inflows) PVIF at 12% Value
1 $29,064 .893 $ 25,954
2 33,960 .797 27,066
3 30,600 .712 21,787
4 17,400 .636 11,066
5 15,672 .567 8,886
6 15,672 .507 7,946
7 15,672 .452 7,084
8 13,560 .404 5,478
9 11,400 .361 4,115
10 11,400 .322 3,671
Present Value of Inflows $123,053
Present Value of Outflows 120,000
Net Present Value $ 3,053
New asset should be purchased.
Calculator Solution:
Chapter 12: The Capital Budgeting Decision
30. Working capital requirements in capital budgeting (LO12-4) The Spartan Technology
Company has a proposed contract with the Digital Systems Company of Michigan. The initial
investment in land and equipment will be $120,000. Of this amount, $70,000 is subject to five-
year MACRS depreciation. The balance is in nondepreciable property. The contract covers six
years; at the end of six years, the nondepreciable assets will be sold for $50,000. The
depreciated assets will have zero resale value.
The contract will require an additional investment of $55,000 in working capital at the
beginning of the first year and, of this amount, $25,000 will be returned to the Spartan
Technology Company after six years.
The investment will produce $50,000 in income before depreciation and taxes for each of
the six years. The corporation is in a 40 percent tax bracket and has a 10 percent cost of capital.
Should the investment be undertaken? Use the net present value method.
Spartan Technology Company
Although there are some complicated features to this problem,
we are still comparing the present value of cash flows to the
total initial investment.
The initial investment is:
Land and equipment ......... $120,000
Working capital ................ 55,000
Initial investment .............. $175,000
In computing the present value of the cash flows, we first
determine annual depreciation based on a $70,000 depreciation
base.
Chapter 12: The Capital Budgeting Decision
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $70,000 .200 $14,000
2 70,000 .320 22,400
3 70,000 .192 13,440
4 70,000 .115 8,050
5 70,000 .115 8,050
6 70,000 .058 4,060
$70,000
We then determine the annual cash flow. In addition to normal
Chapter 12: The Capital Budgeting Decision
Cash Flow Present
Year (Inflows) PVIF @ 10% Value
1 $ 35,600 .909 $ 32,360
2 38,960 .826 32,181
3 35,376 .751 26,567
4 33,220 .683 22,689
5 33,220 .621 20,630
6 106,624 .564 60,136
Present Value of Inflows $194,563
Present Value of Outflows 175,000
Net Present Value $ 19,563
The investment should be undertaken.
Calculator Solution:
Using a financial calculator:
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, press 175,000 +|–, press the Enter key.
Press down arrow, enter 35,600, and press Enter.
Press down arrow, enter 1, and press Enter.
31. Tax losses and gains in capital budgeting (LO12-2) An asset was purchased three years
12-31. Solution:
Chapter 12: The Capital Budgeting Decision
First determine the book value of the asset.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $120,000 .200 $24,000
2 120,000 .320 38,400
3 120,000 .192 23,040
Total Depreciation to Date $85,440
32. Capital budgeting with cost of capital computation (LO12-5) DataPoint Engineering is
considering the purchase of a new piece of equipment for $240,000. It has an eight-year
midpoint of its asset depreciation range (ADR). It will require an additional initial
Chapter 12: The Capital Budgeting Decision
Common equity (retained earnings). ..........
Ke
18.0
50
DataPoint Engineering
a. An eight-year midpoint of the ADR leads to five-year
MACRS depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $ 240,000 .200 $ 48,000
2 240,000 .320 76,800
3 240,000 .192 46,080
4 240,000 .115 27,600
5 240,000 .115 27,600
Chapter 12: The Capital Budgeting Decision
6 240,000 .058 13,920
$240,000
b. Annual Cash Flow
1
2
3
4
5
6
EBDT
$185,000
$160,000
$130,000
$115,000
$95,000
$85,000
Chapter 12: The Capital Budgeting Decision
d. Net Present Value
Cash Flow Present
Year (inflows) PVIF at 15% Value
1 $130,200 .870 $113,274
2 126,720 .756 95,800
3 96,432 .658 63,452
4 80,040 .572 45,783
5 68,040 .497 33,816
6 91,568 .432 39,557
Present Value of Inflows $391,682
* Present Value of Outflows 380,000
Net Present Value $ 11,682
*This represents the $240,000 for the equipment plus the
$140,000 in initial working capital.
The net present value ($11,682) is positive and DataPoint
Engineering should purchase the equipment.
Calculator Solution:
Using a financial calculator:
(d)
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CFo, press 380,000 +|–, press the Enter key.
Press down arrow, enter 130,200 and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 126,720, and press Enter.
Press down arrow, enter 1, and press Enter.
Chapter 12: The Capital Budgeting Decision
33. Replacement decision analysis (LO12-4) Hercules Exercise Equipment Co. purchased a
computerized measuring device two years ago for $58,000. The equipment falls into the
five-year category for MACRS depreciation and can currently be sold for $24,800.
6 ............
The firm’s tax rate is 35 percent and the cost of capital is 12 percent.
a. What is the book value of the old equipment?
b. What is the tax loss on the sale of the old equipment?
c. What is the tax benefit from the sale?
d. What is the cash inflow from the sale of the old equipment?
e. What is the net cost of the new equipment? (Include the inflow from the sale of the
old equipment.)
Chapter 12: The Capital Budgeting Decision
12-33. Solution:
Hercules Exercise Equipment Co.
a.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $58,000 .200 $11,600
2 58,000 .320 18,560
Total Depreciation to Date $30,160
Purchase Price $58,000
– Total Depreciation to Date 30,160
Book Value $27,840
b. Book Value $27,840
Sales Price 24,800
Tax Loss on the Sale $ 3,040
c. Tax Loss on the Sale $ 3,040
Tax Rate 35%
Tax Benefit $ 1,064
d. Sales Price of the Old Equipment $ 24,800
Tax Benefit from the Sale 1,064
Cash Inflow from the Sale of the Old Equipment $ 25,864
e. Price of the New Equipment $148,000
– Cash Inflow from the Sale of the Old Equipment 25,864
Net Cost of the New Equipment $122,136
Chapter 12: The Capital Budgeting Decision
Chapter 12: The Capital Budgeting Decision
(1)
(2)
(3)
(4)
(5)
(6)
Year
Depreciation
on new
Equipment
Depreciation
on old
Equipment
Incremental
Depreciation
Tax
Rate
Tax
Shield
Benefits
1
$29,600
$11,136
$18,464
.35
$ 6,462
2
47,360
6,670
40,690
.35
14,242
3
28,416
6,670
21,746
.35
7,611
4
17,020
3,364
13,656
.35
4,780
(1)
(2)
(3)
(4)
(5)
(6)
Tax Shield
Benefits
Aftertax
Total
Present
Value
Chapter 12: The Capital Budgeting Decision
4
4,780
32,500
37,280
.636
23,710
5
5,957
30,550
36,507
.567
20,699
6
3,004
23,400
26,404
.507
13,387
Present Value of Incremental Benefits
$168,365
k. Present Value of Incremental Benefits $168,365
Net Cost of New Equipment 122,136
Net Present Value $ 46,229
Based on the present value analysis, the equipment should be
replaced.
Calculator Solution:
Using a financial calculator,
Press the following keys: 2nd, CF, 2nd, Clear.
Calculator displays CF0, press 122,136 +|–, press the Enter key.
Press down arrow, enter 46,762, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 49,342, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 41,411, and press Enter.
Press down arrow, enter 1, and press Enter.
Press down arrow, enter 37,280, and press Enter.
Press down arrow, enter 1, and press Enter.
Chapter 12: The Capital Budgeting Decision
6 ..............
45,000
(7,000)
The firm has a 36 percent tax rate and a 9 percent cost of capital. Should the new equipment
be purchased to replace the old equipment?
Chapter 12: The Capital Budgeting Decision
CP 12-1. Solution:
Woodruff Corporation
Book Value of Old Equipment
(ADR of 8 years indicates the use of the 5-year MACRS
schedule)
Year
Depreciation
Base
Percentage
Depreciation
(Table 12-9)
Annual
Depreciation
1
$230,000
.200
$ 46,000
2
230,000
.320
73,600
3
230,000
.192
44,160
Total Depreciation to Date
$163,760
Purchase Price $230,000
– Total Depreciation to Date 163,760
Book Value $ 66,240
Tax Obligation on the Sale
Sales Price $ 90,000
Book Value 66,240
Taxable Gain 23,760
Tax Rate 36%
Taxes $ 8,554
Cash Inflow from the Sale of the Old Equipment
Sales Price $90,000
Taxes 8,554
$81,446
Net Cost of the New Equipment
Chapter 12: The Capital Budgeting Decision
Chapter 12: The Capital Budgeting Decision
(1)
(2)
(3)
(4)
(5)
(6)
Year
Depreciation
on New
Equipment
Depreciation
on Old
Equipment
Incremental
Depreciation
Tax
Rate
Tax
Shield
Benefits
1
$ 64,000
$26,450
$37,550
.36
$13,518
2
102,400
26,450
75,950
.36
27,342
3
61,440
13,340
48,100
.36
17,316
4
36,800
36,800
.36
13,248
Chapter 12: The Capital Budgeting Decision
(1)
(2)
(3)
(4)
(5)
(6)
Year
Tax Shield
Benefits
from
Depreciation
Aftertax
Cost
Savings
Total
Annuity
Benefits
Present
Value
Factor
9%
Present
Value
1
$13,518
$35,200
$48,718
.917
$ 44,674
2
27,342
38,400
65,742
.842
55,355