CHAPTER 26 CAPITAL INVESTMENT ANALYSIS DISCUSSION QUESTIONS The principal objections to the use of the average rate of return method are its failure to consider the expected cash flows from the proposals and the timing of these flows The principal limitations of the cash payback method are its failure to consider cash flows occurring after the payback period and its failure to use present value concepts The average rate of return is not based on cash flows, but on operating income Thus, for example, the average rate of return will include the impact of depreciation, but the internal rate of return will not In addition, the internal rate of return approach will use time value of money concepts, while the average rate of return does not A one-year payback will not equal a 100% average rate of return because the payback period is based on cash flows, while the average rate of return is based on income The depreciation on the project will prevent the two methods from reconciling The cash payback period ignores cash flows occurring after the payback period, which will often include large residual values The majority of the cash flows of a new motion picture are earned within two years of release Thus, the time value of money aspect of the cash flows is less significant for motion pictures than for projects with time-extended cash flows This would favor the use of a cash payback period for evaluating the cash flows of the project The $7,900 net present value indicates that the proposal is desirable because the proposal is expected to recover the investment and provide more than the minimum rate of return The net present values indicate that both projects are desirable, but not necessarily equal in desirability The present value index can be used to compare the two projects For example, assume one project required an investment of $10,000 and the other an investment of $100,000 The present value indexes would be calculated as 0.9 and 0.09, respectively, for the two projects That is, a $9,000 net present value on a $10,000 investment would be more desirable than the same net present value on a $100,000 investment The computations for the net present value method are more complex than those for the methods that ignore present value Also, the method assumes that the cash received from the proposal during its useful life will be reinvested at the rate of return used to compute the present value of the proposal This assumption may not always be reasonable 10 The computations for the internal rate of return method are more complex than those for the methods that ignore present value Also, the method assumes that the cash received from the proposal during its useful life will be reinvested at the internal rate of return This assumption may not always be reasonable 11 The major advantages of leasing are that it avoids the need to use funds to purchase assets and reduces some of the risk of loss if the asset becomes obsolete There may also be some income tax advantages to leasing 12 Quicker delivery of products, higher production quality, and greater manufacturing flexibility are examples of qualitative factors that should be considered 26-1 © 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 26 Capital Investment Analysis PRACTICE EXERCISES PE 26–1A Estimate average annual income Average investment Average rate of return $29,700 ($148,500 ÷ years) $165,000 [($300,000 + $30,000) ÷ 2] 18% ($29,700 ÷ $165,000) PE 26–1B Estimate average annual income Average investment Average rate of return $12,000 ($36,000 ÷ years) $40,000 [($70,000 + $10,000) ÷ 2] 30% ($12,000 ÷ $40,000) PE 26–2A 5.8 years ($787,640 ÷ $135,800) PE 26–2B 4.5 years ($41,850 ÷ $9,300) PE 26–3A a b $4,181 1.11 [($12,200 × 3.605) – $39,800] ($43,981 ÷ $39,800) PE 26–3B a b ($10,546) 0.97 [($96,200 × 3.170) – $315,500] ($304,954 ÷ $315,500) PE 26–4A 10% [($74,035 ÷ $17,000) = 4.355, the present value of an annuity factor for six periods at 10%, from Exhibit 2] PE 26–4B [($362,672 ÷ $76,000) = 4.772, the present value of an annuity factor for nine 15% periods at 15%, from Exhibit 2] PE 26–5A a Present value of $5,000 per year at 12% for years*…………………………… Present value of $12,000 at 12% at the end of years**……………………… Total present value of Project A…………………………………………………… Less total cost of Project A………………………………………………………… Net present value of Project A……………………………………………………… $20,555 6,084 $26,639 22,500 $ 4,139 * [$5,000 × 4.111 (Exhibit 2, 12%, years)] ** [$12,000 × 0.507 (Exhibit 1, 12%, years)] b Project A Project A’s net present value of $4,139 is more than the net present value of Project B, $3,500 PE 26–5B a $38,835 Present value of $15,000 per year at 20% for years*………………………… 18,316 Present value of $38,000 at 20% at the end of years**……………………… Total present value of Project 1…………………………………………………… $57,151 55,000 Less total cost of Project 1…………………………………………………………… Net present value of Project 1……………………………………………………… $ 2,151 * [$15,000 × 2.589 (Exhibit 2, 20%, years)] ** [$38,000 × 0.482 (Exhibit 1, 20%, years)] b Project Project 1’s net present value of $2,151 is less than the net present value of Project 2, $5,000 EXERCISES Ex 26–1 Testing Equipment Vehicle Estimated average annual income: $18,720 ÷ 6……………………………………………………………… $15,360 ÷ 8……………………………………………………………… $3,120 $1,920 Average investment: ($104,000 + $0) ÷ 2……………………………………………………… $52,000 ($32,000 + $0) ÷ 2……………………………………………………… $16,000 Average rate of return: $3,120 ÷ $52,000………………………………………………………… $1,920 ÷ $16,000……………………………………………………… Ex 26–2 Average Rate = of Return 6% 12% Average Annual Income Average Investment Average Savings* – Annual Depreciation – Additional Operating Costs (Beginning Cost + Residual Value) ÷ = = = $34,000 – [($132,000 – $16,000) ÷ 10 years] – $5,380 ($132,000 + $16,000) ÷ $17,020 $74,000 = 23% * The effect of the savings in wages expense is an increase in income Ex 26–3 Average Rate = of Return Average Annual Income Average Investment Average Revenues – Annual Product Costs* (Beginning Cost + Residual Value) ữ = ($410 ì 4,000 units) – ($350 × 4,000 units) = = ($525,000 + $75,000) ÷ $240,000 $300,000 = 80% * The depreciation of the equipment is included in the factory overhead cost per unit Ex 26–4 Year Years 2–9 Last Year $ 272,000 (13,600) $ 272,000 (13,600) (198,600) $ 59,800 (198,600) Initial investment………………………………………… $(107,000) Operating cash flows: Annual revenues (4,000 units × 68)……………… $ 272,000 (13,600) Selling expenses (5% × $272,000)……………… Cost to manufacture (4,000 units × $49.65)*…………………………… (198,600) Net operating cash flows…………………………… $ 59,800 $ (47,200) Total for Year 1………………………………………… Total for Years 2–9 (operating cash flow)………… Residual value……………………………………… Total for last year………………………………………… $ 59,800 $ 59,800 13,000 $ 72,800 * The fixed overhead relates to the depreciation on the equipment Depreciation is not a cash flow and should not be considered in the analysis Thus, $9.00 + $36.00 + $4.65 = $49.65 CHAPTER 26 Capital Investment Analysis Ex 26–5 Location 1: $380,000 ÷ $76,000 = 5-year cash payback period Location 2: 4-year cash payback period, as indicated below Year Year Year Year Cumulative Net Cash Net Cash Flow Flows 1………………………………………………………………………… $120,000 90,000 2……………………………………………………………………… 90,000 3………………………………………………………………………… 80,000 4……………………………………………………………………… $120,000 210,000 300,000 380,000 Ex 26–6 a The Liquid Soap product line is recommended, based on its shorter cash payback period The cash payback period for both products can be determined using the following schedule: Initial investment: $540,000 Liquid Soap Body Lotion Cumulative Year Year Year Year Year Year 1……………………………… 2……………………………… 3……………………………… 4……………………………… 5……………………………… 6……………………………… Cumulative Net Cash Net Cash Net Cash Net Cash Flow Flows Flow Flows $170,000 150,000 120,000 100,000 $170,000 320,000 440,000 540,000 $90,000 90,000 90,000 90,000 90,000 90,000 $ 90,000 180,000 270,000 360,000 450,000 540,000 Liquid Soap has a four-year cash payback period, and Body Lotion has a sixyear cash payback b The cash payback periods are different between the two product lines because Liquid Soap earns cash faster than does Body Lotion Even though both products earn the same total net cash flow over the eight-year planning horizon, Liquid Soap returns cash faster in the earlier years The cash payback method emphasizes the initial years’ net cash flows in determining the cash payback period Thus, the project with the greatest net cash flows in the early years of the project life will be favored over the one with less net cash flows in the initial years CHAPTER 26 Ex 26–7 Capital Investment Analysis Present Value of $1 at 15% a Present Value of Flow Net Cash Flow Year 0.870 $19,000 $16,530 0.756 0.658 23,000 20,000 15,000 17,388 13,160 8,580 $77,000 $55,658 48,500 0.572 Total………………………………………… Less amount to be invested…………… Net present value………………………… b Net Cash $ 7,158 Yes The $7,158 net present value indicates that the return on the proposal is greater than the minimum desired rate of return of 15% Ex 26–8 a Revenues………………… Driver salary……………… Operating costs………… Residual value…………… Annual net cash flow…… b Year 2014 2015 2016 2017 2014 2015 2016 2017 2018 $ 58,000 (42,000) (3,000) $ 58,000 (43,000) (3,000) $ 58,000 (44,000) (3,000) $ 58,000 (45,000) (3,000) $ 13,000 $ 12,000 $ 11,000 $ 10,000 $ 58,000 (46,000) (3,000) 15,000 $ 24,000 Net Cash Flow Present Value Present Value of [from part (a)] of $1 at 12% Net Cash Flow $13,000 12,000 11,000 10,000 0.893 0.797 0.712 0.636 $11,609 9,564 7,832 6,360 2018 24,000 0.567 Total present value of cash flows………………………………………… Less investment in delivery truck………………………………………… Net present value of delivery truck……………………………………… c 13,608 $48,973 55,000 $ (6,027) The total present value of cash flows from the delivery truck investment is less than the total purchase price of the truck That is, the net present value is negative Thus, this analysis does not support investment in the truck Ex 26–9 a in millions Annual revenues………………………………………………………………… Total expenses…………………………………………………………………… $32 Less noncash depreciation expense*………………………………………… Annual cash expenses………………………………………………………… Annual net cash flow…………………………………………………………… $47 28 $19 * Annual depreciation expense, $120 million ÷ 30 years = $4 million per year (in millions except present value factor) b Annual cash flows……………………………………………………………… × Present value of an annuity of $1 at 14% for 30 periods……………… Present value of hotel project cash flows, rounded……………………… Less hotel construction costs………………………………………………… Net present value of hotel project…………………………………………… $ 19 7.00266 * $ 133 120 $ 13 * From Appendix A in the text c The present value of the hotel’s operating cash flows exceeds the construction costs by $13 million That is, the net present value is positive Therefore, construction of the new hotel can be supported by this analysis Ex 26–10 a Cash inflows : 1,500 $ 110 Hours of operation…………………………………… × Revenue per hour…………………………………… Revenue per year……………………………………… $165,000 Cash outflows: Hours of operation……………………………………… Fuel cost per hour………………………………… Labor cost per hour………………………………… × Total fuel and labor costs per hour…………… Fuel and labor costs per year………………………… Maintenance costs per year………………………… Annual net cash flow………………………………… b 1,500 $46 28 $ 74 Annual net cash flow (at the end of each of five years)………… × Present value of annuity of $1 at 10% for five periods………… Present value of annual net cash flows…………………………… Less amount to be invested………………………………………… Net present value……………………………………………………… (111,000) (8,000) $ 46,000 $ 46,000 3.791 $174,386 132,000 $ 42,386 c Yes Briggs should accept the investment because the bulldozer cost is less than the present value of the cash flows at the minimum desired rate of return of 10% d 3.791 [(Hrs × $110) – (Hrs × $74) – $8,000] = $132,000 (Hrs × $417) – (Hrs × $281) – $30,328 = $132,000 Hrs × $136 = $162,328 Hrs = 1,194 (rounded) Thus, the bulldozer operating hours must exceed 1,194 annually in order for the investment to be justified Ex 26–11 a b Revenues (3,600 × 330 days × $340)…………………………………………… Less: Variable expenses (3,600 × 330 days × $140)………………………… Fixed expenses (other than depreciation)……………………………………… Annual net cash flow………………………………………………………………… $403,920,000 (166,320,000) (80,000,000) Present value of annual net cash flows ($157,600,000 × 5.650)…………… Present value of residual value ($140,000,000 × 0.322)……………………… Total present value………………………………………………………………… Less amount to be invested……………………………………………………… Net present value…………………………………………………………………… $890,440,000 45,080,000 Ex 26–12 a b Present Value Index = Total Present Value of Net Cash Flow Amount to Be Invested Present value index = of Blue Springs: $540,750 $525,000 = 1.03 Present value index = of Lee’s Summit: $484,800 $505,000 = 0.96 The analysis supports investing in Blue Springs because the present value index is greater than one The Lee’s Summit investment is not supported $157,600,000 $935,520,000 750,000,000 $185,520,000 Prob 26–2B a Cash payback period for both projects: years (the year in which accumulated net cash flows equal $125,000), shown as follows: Sound Cellar b Year Net Cash Flow Cumulative Net Cash Flow Year Net Cash Flow Cumulative Net Cash Flow $65,000 $ 65,000 $70,000 $ 70,000 60,000 125,000 55,000 125,000 Net present value analysis: Present Net Cash Flow Sound Cellar Present Value of Net Cash Flow Year Value of $1 at 10% 0.909 0.826 $ 65,000 60,000 $ 70,000 55,000 $ 59,085 49,560 $ 63,630 45,430 0.751 25,000 35,000 18,775 26,285 0.683 0.621 25,000 45,000 30,000 30,000 17,075 27,945 20,490 18,630 $220,000 $220,000 Less amount to be invested……………………………………… $172,440 125,000 $174,465 125,000 Net present value…………………………………………………… $ 47,440 $ 49,465 Total…………………………… Pro Gamer Pro Gamer Sound Cellar Pro Gamer The report can take many forms and should include, as a minimum, the following points: a Both projects offer the same total net cash flow b Both projects offer the same cash payback period c Because of the timing of the receipt of the net cash flows, Pro Gamer magazine expansion offers a higher net present value d Both projects provide a positive net present value This means both projects would be acceptable, since they exceed the minimum rate of return Prob 26–3B Branch Office Expansion Present Value Net Cash Year of $1 at 15% Flow 0.870 $200,000 0.756 160,000 160,000 0.658 $520,000 Total……………………………………………… Less amount to be invested…………………………………………… Net present value………………………………………………………… Present Value of Net Cash Flow $ 174,000 120,960 105,280 $ 400,240 (420,000) $ (19,760) Computer System Upgrade Year Present Value of $1 at 15% Net Cash Flow 0.870 $190,000 0.756 180,000 170,000 0.658 $540,000 Total…………………………………………… Less amount to be invested…………………………………………… Net present value………………………………………………………… Present Value of Net Cash Flow $ 165,300 136,080 111,860 $ 413,240 (350,000) $ 63,240 ATM Kiosk Expansion Year Present Value of $1 at 15% Net Cash Flow 0.870 $275,000 0.756 250,000 250,000 0.658 $775,000 Total…………………………………………… Less amount to be invested…………………………………………… Net present value………………………………………………………… Present Value of Net Cash Flow $ 239,250 189,000 164,500 $ 592,750 (520,000) $ 72,750 Prob 26–3B (Concluded) Present Value Index = Amount to Be Invested Total Present Value of Net Cash Flow Present value index of branch office: $400,240 Present value index of computer system: $413,240 Present value index of ATM kiosk: $592,750 $420,000 $350,000 $520,000 = 0.95* = 1.18* = 1.14* * Rounded The computer system upgrade has the largest present value index Although the ATM kiosk expansion has the largest net present value, it returns less present value per dollar invested than does the branch office expansion, as revealed by the present value indexes (1.18 compared to 1.14) (The present value index for the branch expansion is less than 1, indicating that it does not meet the minimum rate of return standard.) Prob 26–4B a After Hours: Annual net cash flow (at the end of each of years)……………………… × Present value of an annuity of $1 at 10% for years (Exhibit 2)………… Present value of annual net cash flows………………………………………… Less amount to be invested……………………………………………………… Net present value………………………………………………………………… $ 320,000 3.170 $1,014,400 913,600 $ 100,800 Sun Fun: Annual net cash flow (at the end of each of years)………………………… × Present value of an annuity of $1 at 10% for years (Exhibit 2)……… Present value of annual net cash flows……………………………………… Less amount to be invested……………………………………………………… Net present value…………………………………………………………………… b Present Value Index = $ 919,300 880,730 $ 38,570 Total Present Value of Net Cash Flow Amount to Be Invested Present value index of After Hours: Present value index of Sun Fun: $1,014,400 $913,600 $919,300 $880,730 * Rounded a $ 290,000 3.170 Present Value Factor for an Annuity of $1 = = 1.11* = 1.04* Amount to Be Invested Annual Net Cash Flow After Hours: $913,600 $320,000 = 2.855 Sun Fun: $880,730 $290,000 = 3.037 b Internal rate of return (determined from Exhibit for years in text) After Hours: 15% Sun Fun: 12% Prob 26–4B (Concluded) The net present value, present value index, and internal rate of return all indicate that After Hours is a better financial opportunity compared to Sun Fun, although both investments meet the minimum return criterion of 10% The present value index indicates that After Hours had a greater present value per dollar of investment The internal rate of return method places all proposals on a common basis As a result, it is possible to compare proposals with different investment amounts, cash flows, and time periods, using the internal rate of return method The internal rate of return method indicates that After Hours’ internal rate of return of 15% is greater than Sun Fun’s internal rate of return of 12% Prob 26–5B Net present value analysis: Witchita: Annual net cash flow (at the end of each of years)……………………………… × Present value of an annuity of $1 at 20% for years (Exhibit 2)……………… Present value of annual net cash flows……………………………………………… Less amount to be invested…………………………………………………………… Net present value………………………………………………………………………… $ 310,000 3.326 $1,031,060 900,000 $ 131,060 Topeka: Annual net cash flow (at the end of each of years)……………………………… × Present value of an annuity of $1 at 20% for years (Exhibit 2)……………… Present value of annual net cash flows……………………………………………… Less amount to be invested…………………………………………………………… Net present value………………………………………………………………………… Net present value analysis: Present Value of Year $1 at 20% $1,035,600 900,000 $ 135,600 Present Value of Net Cash Flow Wichita Topeka 0.833 $ 310,000 $ 400,000 0.694 310,000 400,000 0.579 310,000 400,000 0.482 310,000 400,000 500,000 0.482 (residual value) $1,600,000 To otal………………………………… $1,740,000 Less amount to be invested………………………………………… Net present value……………………………………………………… Net Cash Flow Wichita Topeka $ 258,230 215,140 179,490 149,420 241,000 $ 333,200 277,600 231,600 192,800 $1,043,280 900,000 $ 143,280 $1,035,200 900,000 $ 135,200* * This amount differs from the net present value calculation in part (1) due to rounding of present value factors $ 400,000 2.589 To: Investment Committee Both Wichita and Topeka have a positive net present value This means that both projects meet our minimum expected return of 20% and would be acceptable investments However, if funds are limited and only one of the two projects can be funded, then the two projects must be compared over equal lives Thus, the residual value of Wichita at the end of period is used to equalize the two lives The net present value of the two projects over equal lives indicates that Wichita has a higher net present value and would be a superior investment Prob 26–6B Proposal A: 4-year cash payback period, as follows: Year Net Cash Cumulative Flow Net Cash Flows $120,000 120,000 110,000 100,000 $120,000 240,000 350,000 450,000 Proposal B: 2-year, 4-month cash payback period, as follows: Year months* Net Cash Cumulative Flow Net Cash Flows $100,000 80,000 20,000 $100,000 180,000 200,000 * The net cash flow required is $20,000 out of $60,000 in Year or 1/3 Thus, 1/3 of 12 months is months Proposal C: 3-year, 6-month cash payback period, as follows: Year Net Cash Flow Cumulative Net Cash Flows months* $100,000 90,000 90,000 40,000 $100,000 190,000 280,000 320,000 * The net cash flow required is $40,000 out of $80,000 in Year or 1/2 Thus, 1/2 of 12 months is months Proposal D: 3-year payback period, as follows: Year Net Cash Cumulative Flow Net Cash Flows $200,000 180,000 160,000 $200,000 380,000 540,000 Prob 26–6B (Continued) Proposal A: 5.3% average rate of return, determined as follows: $12,000 $60,000 ÷ = = 5.3% (rounded) $225,000 ($450,000 + $0) ÷ Proposal B: 18.0% average rate of return, determined as follows: $18,000 = 18.0% $90,000 ÷ = $100,000 ($200,000 + $0) ÷ Proposal C: 15.0% average rate of return, determined as follows: $24,000 = 15.0% $120,000 ÷ = $160,000 ($320,000 + $0) ÷ Proposal D: 16.3% average rate of return, determined as follows: $44,000 = 16.3% (rounded) $220,000 ÷ $270,000 = ($540,000 + $0) ÷ Prob 26–6B (Continued) Of the four proposed investments, only Proposals B and D meet the company’s requirements, as the following table indicates: Proposal A B C D Cash Payback Period yrs yrs., mos yrs., mos yrs Average Rate of Return 5.3% 18.0% 15.0% 16.3% Accept for Further Analysis Reject X X X* X * Proposal C is rejected because it fails to meet the maximum payback period requirement, even though it meets the minimum accounting rate of return requirement Proposal B Year Present Value Net Cash Present Value of of $1 at 12% Flow Net Cash Flow 0.893 $100,000 0.797 80,000 0.712 60,000 0.636 30,000 20,000 0.567 Total…………………………………………………………… $290,000 Less amount to be invested…………………………………………………… Net present value………………………………………………………………… $ 89,300 63,760 42,720 19,080 11,340 $226,200 200,000 $ 26,200 Proposal D Year Present Value of $1 at 12% Net Cash Flow 0.893 $200,000 0.797 180,000 0.712 160,000 0.636 120,000 100,000 0.567 $760,000 Total………………………………………………………… Less amount to be invested…………………………………………………… Net present value………………………………………………………………… Present Value of Net Cash Flow $178,600 143,460 113,920 76,320 56,700 $569,000 540,000 $ 29,000 Prob 26–6B (Concluded) Present Value Index = Total Present Value of Net Cash Flow Amount to Be Invested Present value index of Proposal B: $226,200 $200,000 = 1.13* Present value index of Proposal D: $569,000 $540,000 = 1.05* * Rounded Based on the net present value, the proposals should be ranked as follows: Proposal D: $29,000 Proposal B: $26,200 Based on the present value index (the amount of present value per dollar invested), the proposals should be ranked as follows: Proposal B: 1.13 Proposal D: 1.05 The present value indexes indicate that although Proposal D has the larger net present value, it is not as attractive as Proposal B in terms of the amount of present value per dollar invested Proposal D requires the larger investment Thus, management should use investment resources for Proposal B before investing in Proposal D, absent any other qualitative considerations that may impact the decision CASES & PROJECTS CP 26–1 The plant manager wants a project to become accepted and places pressure on the analyst to come up with the “right numbers.” Jerrod is right when he states that the net present value analysis has many assumptions and room for interpretation Many use this room for interpretation to work the numbers until they satisfy the minimum return (hurdle) rate In fact, some analysts state that they start with the hurdle rate and work back into the numbers Clearly, this is not what should be expected of Danielle Danielle made an honest effort to discuss the assumptions Danielle’s last statement was an open attempt to begin a conversation around assumptions This is legitimate Notice that Jerrod jumped on that opening and dictated a course of action Instead of discussing assumptions, Jerrod stated what the assumptions are to be and how they are to be reflected in the analysis This is no more than “cooking” the analysis Danielle needs to respond strongly to this attempt by Jerrod to circumvent the process by countering his argument For example, Danielle might point out that it is by no means clear that more storage space translates into more sales In fact, it is probably just the opposite More storage space means that more product waits a long time before being shipped to the customer This means that the customer is guaranteed to receive dated product that may be inferior to product that has been recently produced More warehouse space is counter to a just-in-time orientation Danielle is really trying to prevent the plant manager from going down the wrong path Jerrod needs to work on his systems so that he doesn’t need the warehouse space This very difficult issue revolves around the nature of ethical dilemmas Danielle has brief tenure with the organization She has very little organizational clout and could easily find her career short-circuited by crossing Jerrod It might be tempting for Danielle to slide on this one—after all, who would know? If the project is eventually a failure, it’s unlikely that the decision would come back to haunt Danielle Much time will have passed, and Danielle will likely be in another job in the company The decision to confront Jerrod has immediate repercussions This is the heart of real-world ethical dilemmas The dilemma occurs when the ethical decision has grave short-term consequences (Jerrod short-circuits the career) and few seemingly long-term rewards (no one sees the ethical decision), while the unethical decision looks appealing in the short term (Jerrod is my friend) and potentially safe in the long term (who’s going to find out?) The ethical management accountant will recognize these pressures and make the difficult decisions in order to build a strong reputation that can be a very powerful asset later in one’s career The key is to recognize that trading off short-term gain for one’s long-term reputation can be very harmful Thus, enlightened self-interest indicates that the ethical course of action to rebuff Jerrod is rational and correct CP 26–2 Annual salary × Present value of $1 annuity for 10 years at 10%…………………………… Present value of undergraduate option as of the end of $ 50,000 6.145 $307,250 undergraduate degree (beginning of graduate degree)………………… Annual tuition at the beginning of the graduate year………………………… Annual salary………………………………………………………………………… × Present value of $1 annuity for years at 10%……………………………… Present value salary to end of graduate year………………………………… × Present value of $1 for years at 10%………………………………………… Present value of salary at the beginning of graduate year………………… Present value of graduate option at beginning of graduate year (salary less tuition) ……………………………………………………… $ (12,000) $ 66,000 5.759 $380,094 0.909 $345,505 $333,505 Note: The present values of parts (1) and (2) must both be determined as of the beginning of the graduate year in order to be compared Thus, the present value of the salary at the end of graduate school must be brought back one period to the beginning of the graduate year, since this salary stream is delayed by one year of schooling The timeline below shows the calculation $ (12,000) $345,505 10 66K 66K 66K 66K 66K 66K 66K 66K 66K (66,000 × 5.759 × 0.909) $333,505 Present value of graduate option…………………………………………………… Present value of undergraduate option…………………………………………… Net benefit of graduate option……………………………………………………… $333,505 307,250 $ 26,255 Note to Instructors: This solution accounts for the opportunity cost of graduate school in terms of lost earnings during the graduate year To maintain simplicity, the solution does not account for likely growth in earnings over time or income tax effects In addition, the undergraduate tuition and opportunity cost to obtain the undergraduate degree are treated as sunk costs relative to the decision to attend graduate school and, thus, are not relevant to the analysis CP 26–3 a Since all the net cash flows are incurred in the local economy under this assumption, it is likely that the internal rate of return of the new plant will decline This is because the cash profits earned on the plant will be less in U.S dollars as a result of the devaluation For example, if the product sold for a profit of 10 units of local currency, it would need to double to 20 units of local currency in order to generate the same U.S dollars of profit This could be done with a large price increase However, such a price increase would probably significantly reduce demand If the price stayed the same, then the number of U.S dollars earned in profit would be halved b If the plant produced for export only, then the expenses would be incurred in local currency, while the revenues would be earned in U.S dollars This could work in favor of the project because the expenses in U.S dollar terms would decline For example, if the local wages were 16 units of local currency per hour, then after the devaluation, these 16 units would cost half as much in U.S dollar terms Since the product is sold in the United States, the currency exchange rate would have no impact on revenues The net result is that the cash flows in U.S dollar terms would potentially increase, increasing the internal rate of return CP 26–4 In all three companies, the executives indicate that financial investment analysis plays a minor role in the selection of projects The reason is that all three companies deal with products that have highly uncertain future cash flows Thus, any attempt at a financial investment analysis could be highly suspect Instead, these managers rely on strategic considerations These considerations include responding to competitors, developing new markets and products for customers, and improving quality The executives indicate that business judgment is more important for these strategic, longer-term decisions than is financial investment analysis This suggests that financial investment analysis is better suited for investments that have more predictable cash flows with possible short duration CP 26–5 a All cash flows assumed to occur at the end of the year All amounts are 2014 cash flow: in millions Gross ticket sales……………………………………………………………… Production cost……………………………………………………………… Marketing cost………………………………………………………………… Net cash flow from theatrical release………………………………………… $ 420 (340) (90) $ (10) 2015 Online download sales…………………………………………………… 2016 Pay TV……………………………………………………………………… 2017 Syndication…………………………………………………………………… $ 60 20 10 Net present value: Year Present Value Net Cash Present Value of of $1 at 20% Flow Net Cash Flow 2014 0.833 $(10) 2015 0.694 60 2016 0.579 20 2017 0.482 10 Net present value………………………………………………………………… b $ (8) 42 12 $51 Even though the film lost money at the box office, the project was financially successful as a whole, due to additional cash flows from online downloads, pay TV, and network TV syndication CP 26–6 This activity could be assigned individually or in groups This activity has the student(s) perform a capital investment analysis for a desktop computer, using information available to them on the Internet and from a local business The actual answer depends on the actual numbers determined by the student(s) Have a number of students (or groups) provide their answers to the class and note the variation (or lack thereof) between the various analyses Use this to show that there are often many answers to even simple problems, depending on the assumptions (e.g., what is considered a “mid-range” computer) and underlying data (e.g., rental rate) Below is a sample answer based on our own data and assumptions: Assumed hourly rental rate………………………………………………… Semester cost (40 hours × $8)…………………………………………… Present value of $320 for semiannual periods at 5% ($320 × 5.07569)…………………………………………………………… Less assumed price of a mid-range computer………………………… Net present value…………………………………………………………… The computer should be purchased $8 per hour $320 $1,624 1,200 $ 424 ... years Ex 26 21 Processing Mill Present Value Year of $1 at 15% Net Cash Present Value of Flow Net Cash Flow $ 310,000 $269 ,700 0.870 0.756 0.658 260 ,000 260 ,000 196,560 171,080 0.572 260 ,000 148,720... 26 2A 5.8 years ($787,640 ÷ $135,800) PE 26 2B 4.5 years ($41,850 ÷ $9,300) PE 26 3A a b $4,181 1.11 [($12,200 ì 3.605) $39,800] ($43,981 ữ $39,800) PE 26 3B a b ($10,546) 0.97 [($96,200 × 3.170)... should not be considered in the analysis Thus, $9.00 + $36.00 + $4.65 = $49.65 CHAPTER 26 Capital Investment Analysis Ex 26 5 Location 1: $380,000 ÷ $76,000 = 5-year cash payback period Location 2: