143891606 Capital Budgeting Solutions Manual Ch10 PDF

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CHAPTER 10 The Fundamentals of Capital Budgeting

Before You Go On Questions and Answers Section 10.1 1.

Why are capital investments considered the most important decisions made by a firm’s management? Capital investments are the most important decisions made by a firm’s management, because they usually involve large cash outflows and once made are not easily reversed. These are usually long-term projects that will define the firm’s line of business and significantly contribute to the total revenue figure for years to come.

2.

What are the differences between capital projects that are independent, mutually exclusive, and contingent?

A project is independent if the decision to accept or reject it does not affect the decision to accept or reject another project. On the other hand, projects are mutually exclusive if the acceptance of one implies rejection of the other. Contingent projects are those in which the acceptance of one project is dependent on another project.

Section 10.2 1.

What is the NPV of a project? NPV is simply the difference between the present value of a project’s expected future cash flows and its cost. It is the recommended technique used to value capital investments, as it takes into account both the timing of the cash flows and their risk.

2.

If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the firm?

If a firm accepts a project with a $10,000 NPV, it will increase its value by $10,000. 3.

What are the five steps used in NPV analysis? The five-step process used in the NPV analysis can be listed as follows: (1) Determine the cost of the project. (2) Estimate the project’s future cash flows over its expected life. (3) Determine the riskiness of a project and the appropriate cost of capital. (4) Compute the project’s NPV. (5) Make a decision.

Section 10.3 1.

What is the payback period?

The payback period is defined as the number of years it takes to recover the project’s initial investment. All other things being equal, the project with the shortest payback period is usually the optimal investment.

2.

Why does the payback period provide a measure of a project’s liquidity risk? The payback period determines how quickly you recover your investment in a project. Thus, it serves as a good measure of the project’s liquidity.

3.

What are the main shortcomings of the payback method? The payback method does not account for time value of money, nor does it distinguish between high- and low-risk projects. In addition, there is no rationale behind choosing the cutoff criteria. For all these reasons, the payback method is not the ideal capital decision rule.

Section 10.4 1.

What are the major shortcomings of using the ARR method as a capital budgeting method? The biggest shortcoming of using ARR as a capital budgeting tool is that it uses historical, or book value data rather than cash flows and thus disregards the time value of money principle. In addition, as in the payback method, it fails to establish a rationale behind picking the appropriate hurdle rate.

Section 10.5 1.

What is the IRR method?

The IRR, or the internal rate of return, is the discount rate that makes the net present value of the project’s future cash flows zero. The IRR determines whether the project’s return rate is higher or lower than the required rate of return, which is the firm’s cost of capital. As a rule, a project should be accepted if the IRR exceeds the firm’s cost of capital; otherwise the project should be rejected. 2.

In capital budgeting, what is a conventional cash flow pattern? A conventional project cash flow in capital budgeting is one in which an initial cash outflow is followed by one or more future cash inflows.

3.

Why should the NPV method be the primary decision tool used in making capital investment decisions? Given all the different methods to evaluate capital investment decisions, the NPV method is the preferred valuation tool as it accounts for both time value of money and the project’s risk. Furthermore, NPV is not sensitive to nonconventional projects, and

therefore it is superior to the IRR technique and it gives a measure of the value increase/decrease to the firm by undertaking the project.

Section 10.6 1.

What changes have taken place in the capital budgeting techniques used by U.S. companies?

Over the years, there has been a shift from using payback and ARR as the primary capital budgeting tools to using NPV and IRR instead. Managers today understand the importance of the time value of money and discounting and thus regard ARR as an inaccurate and obsolete decision tool.

Self-Study Problems 10.1

Premium Manufacturing Company is evaluating two forklift systems to use in its plant that produces the towers for a windmill power farm. The costs and the cash flows from these systems are shown below. If the company uses a 12 percent discount rate for all projects, determine which forklift system should be purchased using the net present value (NPV) approach. Year 0

Year 1

Year 2

Year 3

Otis Forklifts

−$3,123,450

$979,225

$1,358,886

$2,111,497

Craigmore Forklifts

−$4,137,410

$875,236

$1,765,225

$2,865,110

Solution: NPV for Otis Forklifts:

n

NPV = ∑

CFt

t = 0 (1 + k )

t

= −$3,123,450 +

$979,225 1

+

$1,358,886

+

$1,765,225

2

+

$2,111,497

+

$2,865,110

(1 + 0.12) (1.12) (1.12) 3 = − $3,123,450 + $874,308 + $1,083,296 + $1,502,922 = $337,075

NPV for Craigmore Forklifts:

n

NPV = ∑

CFt

t = 0 (1 + k )

t

= −$4,137,410 +

$875,236 1

2

(1 + 0.12) (1.12) (1.12) 3 = −$4,137,410 + $781,461 + $1,407,229 + $2,039,227 = $90,606

Premium should purchase the Otis forklift since it has a larger NPV.

10.2

Rutledge, Inc., has invested $100,000 in a project that will produce cash flows of $45,000, $37,500, and $42,950 over the next three years. Find the payback period for the project.

Solution: Payback period for Rutledge project: Cumulative Year

CF

Cash Flow

0

(100,000)

(100,000)

1

45,000

(55,000)

2

37,500

(17,500)

3

42,950

25,450

Payback period = Years before cost recovery +

Remaining cost to recover Cash flow during the year

$17,500 $42,950 per year = 2.41years =2+

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 2 + ($17,500 / $42,950) = 2.41 years

10.3

Perryman Crafts Corp. is evaluating two independent capital projects that together will cost the company $250,000. The two projects will provide the following cash flows:

Year

Project A

Project B

1

$80,750

$32,450

2

$93,450

$76,125

3

$40,325

$153,250

4

$145,655

$96,110

Which project will be chosen if the company’s payback criterion is three years? What if the company accepts all projects as long as the payback period is less than five years?

Solution: Payback periods for Perryman projects A and B: Project A Cumulative Year

Cash Flow

Cash Flows

0

$(250,000)

$(250,000)

1

80,750

(169,250)

2

93,450

(75,800)

3

40,235

(35,565)

4

145,655

110,090

Project B Cumulative Year

Cash Flow

Cash Flows

0

$(250,000)

$(250,000)

1

32,450

(217,550)

2

76,125

(141,425)

3

153,250

11,825

4

96,110

107,935

Payback period for Project A: Payback period = Years before cost recovery +

Remaining cost to recover Cash flow during the year

$35,565 $145,655 per year = 3.24 years

=3+

Payback period for Project B:

Payback period = Years before cost recovery +

Remaining cost to recover Cash flow during the year

$141,425 $153,250 per year = 2.92 years

=2+

If the payback period is three years, only project B will be chosen. If the payback criterion is five years, both A and B will be chosen.

10.4

Terrell Corp. is looking into purchasing a machine for its business that will cost $117,250 and will be depreciated on a straight-line basis over a five-year period. The sales and expenses (excluding depreciation) for the next five years are shown in the following table.

The company’s tax rate is 34 percent.

Year 1 Year 2 Year 3 Year 4 Year 5 The company w$123,450 ill accept all projects that pr ovi de an ac counting rate of return (ARR ) of at least 45 percent. Sales $176,875 $242,455 $255,440 $267,125 Expenses

$137,410

$126,488

$141,289

$143,112

$133,556

The company will accept all projects that provide an accounting rate of return (ARR) of at least 45 percent. Should the company accept the project?

Solution: Year 1

Sales

Year 2

$123,450 $176,875

Expenses Depreciation EBIT Taxes (34%)

Year 4

Year 5

$242,455

$255,440

$267,125

137,410

126,488

141,289

143,112

133,556

23,450

23,450

23,450

23,450

23,450

$ (37,410) $ 26,937

$ 77,716

$ 88,878

$110,119

9,159

26,423

30,219

37,440

$ (24,691) $ 17,778

$ 51,293

$ 58,659

$ 72,679

12,719

Net Income

Year 3

Beginning Book Value

117,250

93,800

70,350

46,900

23,450

Less: Depreciation

(23,450)

(23,450)

(23,450)

(23,450)

(23,450)

Ending Book Value

$ 93,800 $ 70,350

$ 46,900

$ 23,450

$

0

Average net income

= (–$24,691 + $17,778 + $51,293 + $58,659 + $72,679) / 5 = $35,143.60

Average book value

= (1$117,250 + $93,800 + $70,350 + $46,900 + $23,450 + $02)/6 = $58,625

Accounting rate of return

= $35,143.6 / $58,625 = 0.599 or 59.9%

The company should accept the project.

10.5

Refer to Problem 10.1. Compute the IRR for each of the two systems. Is the investment decision different from the one determined by NPV?

Solution:

IRR for two forklift systems: Otis Forklifts: First compute the IRR by the trial-and-error approach: NPV (Otis) = $337,075 > 0 Use a higher discount rate to get NPV = 0! At k = 15%, $979,225 $1,358,886 $2,111, 497 + + (1 + 0.15)1 (1.15)2 (1.15)3 = − $3,123, 450 + $851,500+ $1,027,513+ $1,388,344 = $143,907.

NPVOtis = − $3,123, 450 +

Try a higher rate. At k = 17%,

NPVOtis = − $3,123,450 + $836,944 + $992,685 + $1,318,357 = $24,536. Try a higher rate. At k = 17.5%,

NPVOtis = − $3,123,450 + $833,383 + $984,254 + $1,301,598 = − $4,215 Thus the IRR for Otis is less than 17.5 percent. Using a financial calculator, you can find that the exact rate to be 17.43 percent. Craigmore Forklifts: First compute the IRR by the trial-and-error approach: NPV (Craigmore) = $90,606 > 0 Use a higher discount rate to get NPV = 0! At k = 15%, $875, 236 $1, 765, 225 $2,865,110 + + (1.15)1 (1.12)2 (1.12)3 = −$4,137, 410 + $761,075 + $1, 334, 764 + $1,883,856

NPVCraigmore = −$4,137, 410 + = −$157,715

Try a lower rate. At k = 13%,

NPVCraigmore = −$4,137,410 + $774,545 + $1,382,430 + $1,985,665 = $5, 230 Try a higher rate. At k = 13.1%,

NPVCraigmore = −$4,137,410 + $773,860 + $1,379,987 + $1,980,403 = −$3,161 Thus the IRR for Craigmore is less than 13.1 percent. The exact rate is 13.06 percent. Based on the IRR, we would still pick Otis over Craigmore forklift systems. The decision is the same as that indicated by NPV

Critical Thinking Questions 10.1

Explain why the cost of capital is referred to as the “hurdle” rate in capital budgeting. The cost of capital is the minimum required return on any new investment that allows a firm to break even. Since we are using the cost of capital as a benchmark or “hurdle” to compare the return earned by any project, it is sometimes referred to as the hurdle rate.

10.2

a. A company is building a new plant on the outskirts of Smallesville. The town has

offered to donate the land, and as part of the agreement, the company will have to build an access road from the main highway to the plant. How will the project of building the road be classified in capital budgeting analysis?

b. Sykes, Inc., is considering two projects: a plant expansion and a new computer

system for the firm’s production department. Classify these projects as independent, mutually exclusive, or contingent projects and explain your reasoning. c. Your firm is currently considering the upgrading of the operating systems of all the

firm’s computers. The firm can choose the Linux operating system that a local

computer services firm has offered to install and maintain. Microsoft has also put in a bid to install the new Windows operating system for businesses. What type of project is this? a. This is a contingent project. Acceptance of the road-building project is contingent

on the new plant being a financially viable project. If the new plant will not have a positive value, then the firm will not even consider this project. However, this project’s cost will have to be considered along with the cost of building the new plant in the capital budgeting analysis. b. These two projects are independent projects. Accepting or rejecting one will not

influence the decision on the other project. The cash flows of the two projects are unrelated. c. These are two mutually exclusive projects. The company’s computers need only

one operating system. Either the Linux or the Windows operating system needs to be installed, not both. Hence, the selection of one will eliminate the other from consideration.

10.3

In the context of capital budgeting, what is “capital rationing”? Capital rationing implies that a firm does not have the resources necessary to fund all of the available projects. In other words, funding needs exceed funding resources. Thus, the available capital will be allocated to the projects that will benefit the firm and its shareholders the most. Projects that create the largest increase in shareholder wealth will be accepted until all the available resources have been allocated.

10.4

Provide two conditions under which a set of projects might be characterized as mutually exclusive.

When projects are mutually exclusive, acceptance of one project precludes the acceptance of others. Typically, mutually exclusive projects perform the same function and so only one of them needs to be accepted. A funding or resource constraint can also cause projects to be mutually exclusive.

10.5

a. A firm invests in a project that would earn a return of 12 percent. If the appropriate

cost of capital is also 12 percent, did the firm make the right decision. Explain.

b. What is the impact on the firm if it accepts a project with a negative NPV? a. We would normally argue that a firm should only accept projects in which the

project’s return exceeds the cost of capital. In other words, only if the net present value exceeds zero should a project be accepted. But in reality, projects with a zero NPV should also be accepted because the project earns a return that equals the cost of capital. For some firms like the one above, this could be the situation because they may not have projects that provide a return greater than the cost of capital for the firm. b. When a firm takes on positive NPV projects, the value of the firm increases. By

the same token, when a project undertaken has a negative NPV, the value of the firm will decrease by the amount of the net present value.

10.6

Identify the weaknesses of the payback period method. There are several critical weaknesses in the payback period approach of evaluating capital projects. 

The payback period ignores the time value of money by not discounting future cash flows.



When comparing projects, it ignores risk differences between the projects.



A firm may establish payback criteria with no economic basis for that decision and thereby run the risk of losing out on good projects.



The method ignores cash flows beyond the payback period, thus leading to nonselection of projects that may produce cash flows well beyond the payback period or more cash flows than accepted projects. This leads to a bias against longer-term projects.

10.7

What are the strengths and weaknesses of the accounting rate of return (ARR) approach? The biggest advantage of ARR is that it is easy to compute since accounting data is readily available, whereas estimating cash flows is more difficult. However, the disadvantages outweigh this specific advantage. Similar to the payback, it does not discount cash flows, but merely averages net income over time. No economic rationale is used in establishing an ARR cutoff rate. Finally, the ARR uses net income to evaluate the project and not cash flows or market data. This is a serious flaw in this approach.

10.8

Under what circumstances might the IRR and NPV approaches have conflicting results?

IRR and the NPV methods of evaluating capital investment projects might produce dissimilar results under two circumstances. First, if the project’s cash flows are not conventional—that is, if the sign of the cash flow changes more than once during the life of a project—then multiple IRRs can be obtained as solutions. We would be unable to identify the correct IRR for decision making. (See Learning by Doing Application 10.3.) The second situation occurs when two or more projects are mutually exclusive. The project with the highest IRR may not necessarily be the one with the highest NPV and thereby be the right choice. There is an important reason for this. IRR assumes that all cash flows received during the life of a project are reinvested at the IRR, whereas the NPV method assumes that they are reinvested at the cost of capital. Since the cost of ca...