Chapter 13 Capital Investment Decision PDF

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STRATEGIC COST MANAGEMENT - Solutions ManualCHAPTER 13CAPITAL INVESTMENT DECISIONSAnswer to Questions A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on these funds over a relatively extended period of time in the future. Cost of c...

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STRATEGIC COST MANAGEMENT - Solutions Manual

CHAPTER 13 CAPITAL INVESTMENT DECISIONS Answer to Questions 1. A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on these funds over a relatively extended period of time in the future. 2. Cost of capital is the weighted minimum desired average rate that a company must pay for longterm capital while discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. 3. The basic principles in capital budgeting are: 1. Capital investment models are focused on the future cash inflows and outflows - rather than on net income. 2. Investment proposals should be evaluated according to their differential effects on the company’s cash flows as a whole. 3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to avoid the “double-counting” of the cost of money. 4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of future return. 5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability constraint. 4. The major classifications as to purpose are: 1. Replacement projects - those involving replacements of worn-out assets to avoid disruption of normal operations, or to improve efficiency. 2. Product or process improvement - projects that aim to produce additional revenue or to realize cost savings. 3. Expansion - projects that enhance long-term returns due to increased profitable volume. 5. Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total investment. 6. No. This implies that any equity funds are cost free and this is a dangerous position because it ignores the opportunity cost or alternative earnings that could be had from the fund. 7. Yes, if there are alternative earnings foregone by stockholders. 8. Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15% rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects, each of which has passed the hurdle. 9. The “time value of money” refers to the fact that a peso received today is more valuable than a peso received in the future. A peso received today can be invested to yield more than a peso in the future. 10. Discounting is the process of computing the present value of a future cash flow. Discounting gives recognition to the time value of money and makes it possible to meaningfully add together cash flows that occur at different times.

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11. Accounting net income is based on accruals rather than on cash flows. Both the net present value and internal rate of return methods focus on cash flows. 12. One simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. 13. No. The cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the individual costs of all sources of financing, both debt and equity. 14. The internal rate of return is the rate of return on an investment project over its life. It is computed by finding that discount rate that results in a zero net present value for the project. 15. The project profitability index is computed by dividing the net present value of the cash flows from an investment project by the investment required. The index measures the profit (in terms of net present value) provided by each peso of investment in a project. The higher the project profitability index, the more desirable is the investment project. 16. Neither the payback method nor the simple rate of return method considers the time value of money. Under both methods, a peso received in the future is weighed the same as a peso received today. Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered. Answer to Matching Type 1. 2. 3. 4. 5.

A C F B I

6. 7. 8. 9. 10.

H D G J E

Answer to Exercises Exercise 1 (Simple Rate of Return Method) The annual incremental net operating income is determined by comparing the operating cost of the old machine to the operating cost of the new machine and the depreciation that would be taken on the new machine: P33,00 Operating cost of old machine................................. 0 Less operating cost of new machine........................ 10,000 Less annual depreciation on the new machine (P80,000 ÷ 10 years)............................................ 8,000 P15,00 Annual incremental net operating income............... 0 Cost of the new machine......................................... Less scrap value of old machine.............................. Initial investment.....................................................

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P80,00 0 5,000 P75,00 0

Simple rate of return

Annual incremental net operating income Initial investment P15,000 = P75,000 = 20% Exercise 2 (Basic Present Value Concepts) =

1. a. P400,000 × 0.794 = P317,600. b. P400,000 × 0.712 = P284,800. 2. a. P5,000 × 4.355 = P21,775. b. P5,000 × 3.685 = P18,425. 3. The factor for 10% for 20 years is 8.514. Thus, the present value of Tom’s winnings would be: P50,000 × 8.514 = P425,700. Whether or not Tom really won a million pesos depends on your point of view. She will receive a million pesos over the next 20 years; however, in terms of its value right now she won much less than a million pesos as shown by the present value computation above. Exercise 3 (After-Tax Costs) a. Management consulting fee.............. Multiply by 1 – 0.30........................... After-tax cost.....................................

P100,000 × 0.70 P 70,000

b. Increased revenues........................... Multiply by 1 – 0.30........................... After-tax cash flow (benefit)..............

P40,000 × 0.70 P28,000

c.

The depreciation deduction is P210,000 ÷ 7 years = P30,000 per year, which has the effect of reducing taxes by 30% of that amount, or P9,000 per year.

Exercise 4 (Basic Net Present Value Analysis) Amount of Year(s) Cash Flows Purchase of the stock......... Now P(18,000) Annual dividends*.............. 1-4 P720 Sale of the stock................. 4 P22,500 Net present value............... *900 shares × P0.80 per share per year = P720 per year.

12% Present Value of Factor Cash Flows 1.000 P(18,000) 3.037 2,187 0.636 14,310 P( 1,503)

No, Ms. Cruz did not earn a 12% return on the share. The negative net present value indicates that the rate of return on the investment is less than the discount rate of 12%. Exercise 5 (Internal Rate of Return and Net Present Value) Factor of the internal Required investment 1. = rate of return Annual cash inflow =

P136,700 P25,000

=

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5.468

A factor of 5.468 represents an internal rate of return of 16%. 2. Item Initial investment.......................... Net annual cash inflows................ Net present value..........................

Year(s) Now 1-14

Amount of Cash Flows P(136,700) P25,000

16% Factor 1.000 5.468

Present Value of Cash Flows P(136,700) 136,700 P 0

The reason for the zero net present value is that 16% (the discount rate) represents the machine’s internal rate of return. The internal rate of return is the rate that causes the present value of a project’s cash inflows to just equal the present value of the investment required. 3. Factor of the internal = rate of return

Required investment Annual cash inflow

P136,700 The 6.835 factor is closest to 6.982, the factor for=the 6.835 11% rate of return. Thus, to the nearest whole = P20,000 percent, the internal rate of return is 11%. Exercise 6 (Basic Net Present Value and Internal Rate of Return Analysis) 1. Item Initial investment.................... Annual cash inflows............... Net present value....................

Year(s) Now 1-4

Amount of Cash Flows P(40,350) P15,000

15% Factor 1.000 2.855

Present Value of Cash Flows P(40,350) 42,825 P 2,475

Yes, this is an acceptable investment. Its net present value is positive, which indicates that its rate of return exceeds the minimum 15% rate of return required by the company. 2.

Factor of the internal = rate of return =

Investment required Net annual cash inflow P111,500 P20,000

=

5.575

A factor of 5.575 represents an internal rate of return of 16%. 3.

Factor of the internal = rate of return

Investment required Net annual cash inflow

P14,125 A factor of 5.650 represents= an internal rate of return of 12%. The company did not make a wise = 5.650 P2,500 investment because the return promised by the machine is less than the required rate of return.

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Answer to Problems Problem 1 (Equipment Replacement Sensitivity Analysis) Requirement 1 Total Present Value A.

B.

New Situation: Recurring cash operating costs (P26,500 x 2.69) Cost of new equipment Disposal value of old equipment now Present value of net cash outflows Present Situation: Recurring cash operating costs (P45,000 x 2.69) Disposal value of old equipment four years hence (P2,600 x 0.516) Present value of net cash inflows Difference in favor of replacement

P 71,285 44,000 (5,000) P110,285 P121,050

(1,342) P119,708 P 9,423

Requirement 2 Payback period for the new equipment = =

P44,000 – P5,000 P18,500 2.1 years

Requirement 3 Let X = annual cash savings Let O = net present value X (2.69) + P5,000 - P44,000 - P1,342 = O 2.69X = P40,342 X = P14,997 If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the point of indifference will be reached. Another alternative way to get the same answer would be to divide the net present value of P9,423 by 2.690. Problem 2 Annual cash expenses of the manual bookkeeping machine system, P9,800 x 12 Annual cash expenses of computerized data processing Annual cash savings before taxes Annual cash savings (a)

Year 1 P64,000

Year 2 P64,000

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Year 3 P64,000

P117,600 53,600 P 64,000

Depreciation Inflow before tax Income tax (50%) (b) Cash inflow after tax (a b)

Year 1 Year Year Year Year

2 3 3 Salvage 3 Tax loss

20,000 P44,000 22,000 P42,000

After Tax Cash Inflows P42,00 0 40,000 38,400 20,000 15,600*

16,000 P48,000 24,000 P40,000

12,800 P51,200 25,600 P38,400

PV Factor

PV

x0.909

P 38,178 33,040 28,800 15,000 11,70 0 P126,71 8 100,00 0 P 26,718

x 0.826 x 0.750 x 0.750 x 0.750

Investment (I) Net present value (NPV) _________________ *

The P15,600 tax benefit of the loss on the disposal of the computer at the end of year 3 is computed as follows: Estimated salvage value Estimated book value: Historical cost P100,000 Accumulated depreciation 48,800 Estimated loss Tax rate Tax effect of estimated loss

P 20,000

51,200 P(31,200) 50% P(15,600)

Since the net present value is positive, the computer should be purchased replacing the manual bookkeeping system.

Problem 3 Requirement 1 (a) Purchase price of new equipment Disposal of existing equipment: Selling price Book value Loss on disposal Tax rate 0.4 Tax benefit of loss on disposal Required investment (I)

P(300,000) P 0 60,000 P60,000 24,000 P(276,000)

(b) Increased cash flows resulting from change in contribution margin: Using new equipment [18,000 (P20 - P7)] *

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P234,000

Using existing equipment [11,000 (P20 - P9)] Increased cash flows Less: Taxes (0.40 x P113,000) Increased cash flows after taxes Depreciation tax shield: Depreciation on new equipment (P300,000  5) Depreciation on existing equipment (P60,000  5) Increased depreciation charge Tax rate 0.40 Depreciation tax shield Recurring annual cash flows _________________ *

121,000 113,000 45,200 P 67,800 P60,000 12,000 P48,000 19,200 P 87,000

The new equipment is capable of producing 20,000 units, but ETC Products can sell only 18,000 units annually. The sales manager made several errors in his calculations of required investment and annual cash flows. The errors are as follows: Required investment: - The cost of the market research study (P44,000) is a sunk cost because it was incurred last year and will not change regardless of whether the investment is made or not. - The loss on the disposal of the existing equipment does not result in an actual cash cost as shown by the sales manager. The loss on disposal results in a reduction of taxes, which reduces the cost of the new equipment. Annual cash flows: - The sales manager considered only the depreciation on the new equipment rather than just the additional depreciation which would result from the acquisition of the new equipment. - The sales manager also failed to consider that the depreciation is a noncash expenditure which provides a tax shield. - The sales manager’s use of the discount rate (i.e., cost of capital) was incorrect. The discount rate should be used to reduce the value of future cash flows to their current equivalent at time period zero.

Requirement 2 Present value of future cash flows (P87,000 x 3.36)P292,320 Required investment (I) 276,000 Net present value P 16,320 Problem 4 Requirement 1: P(507,000) Requirement 2: P(466,200) Requirement 3: P(23,400) Problem 5 1. The net annual cost savings is computed as follows: Reduction in labor costs.................................................. Reduction in material costs............................................. Total cost reductions........................................................ Less increased maintenance costs (P4,250 × 12)........... Net annual cost savings..................................................

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P240,000 96,000 336,000 51,000 P285,000

2. Using this cost savings figure, and other data provided in the text, the net present value analysis is: Cost of the machine....................... Installation and software................ Salvage of the old machine............ Annual cost savings....................... Overhaul required.......................... Salvage of the new machine.......... Net present value..........................

Amount of 18% Present Value Cash Flows Factor of Cash Flows P(900,000) 1.000 P (900,000) P(650,000) 1.000 (650,000) P70,000 1.000 70,000 P285,000 4.494 1,280,790 P(90,000) 0.370 (33,300) P210,000 0.191 40,110 P (192,400)

Year(s) Now Now Now 1-10 6 10

No, the etching machine should not be purchased. It has a negative net present value at an 18% discount rate. 3. The intangible benefits would have to be worth at least P42,813 per year as shown below: Required increase in net present value Factor for 10 years

=

P192,400 = 4.494

P42,813

Thus, the new etching machine should be purchased if management believes that the intangible benefits are worth at least P42,813 per year to the company. Problem 6 (2) Tax Effect

(1) Items and Computations Year(s) Amount Investment in new trucks...................Now P(450,000) Salvage from sale of the old trucks.............................................Now P30,000 1 – 0.30 Net annual cash receipts.................... 1-8 P108,000 1 – 0.30 Depreciation deductions*................... 1-8 P56,250 0.30 Overhaul of motors............................ 5 P(45,000) 1 – 0.30 Salvage from the new trucks.............. 8 P20,000 1 – 0.30 Net present value...............................

Present (1) × (2) Value of After-Tax Cash Cash 12% Flows Flows Factor P(450,000) 1.000 P(450,000) P21,000 1.000 P75,600 4.968 P16,875 4.968 P(31,500) 0.567 P14,000 0.404

21,000 375,581 83,835 (17,861) 5,656 P 18,211

* P450,000 ÷ 8 years = P56,250 per year

Since the project has a positive net present value, the contract should be accepted. Problem 7 1.

Factor of the internal = rate of return =

Required investment Annual cash inflow P142,950 P37,500

=

3.812

A factor of 3.812 equals an 18% rate of return. Verification of the 18% rate of return: Item

Year(s)

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Amount of

18%

Present Value

Investment in equipment........... Annual cash inflows................... Net present value....................... 2.

Factor of the internal = rate of return

Now 1-7

Cash Flows P(142,950) P37,500

Factor 1.000 3.812

of Cash Flows P(142,950) 142,950 P 0

Required investment Annual cash inflow

We know that the investment is P142,950, and we can determine the factor for an internal rate of return of 14% by looking at the PV table along the 7-period line. This factor is 4.288. Using these figures in the formula, we get: P142,950 = 4.288 Annual cash inflow Therefore, the annual cash inflow would have to be: P142,950 ÷ 4.288 = P33,337. 3. a. 5-year life for the equipment: The factor for the internal rate of return would still be 3.812 [as computed in (1) above]. Reading along the 5-period line of the PV table, a factor of 3.812 is closest to 3.791, the factor for 10%. Thus, to the nearest whole percent, the internal rate of return is 10%. b. 9-year life for the equipment: The factor of the internal rate of return would again be 3.812. From the PV table, reading along the 9-period line, a factor of 3.812 is closest to 3.786, the factor for 22%. Thus, to the nearest whole percent, the internal rate of return is 22%. The 10% return in part (a) is less than the 14% minimum return that Dr. Blue wants to earn on the project. Of equal or even greater importance, the following diagram should be pointed out to Dr. Blue:

As this illustration shows, a decrease in years has a much greater impact on the rate of return than an increase in years. This is because of the time value of money; added cash inflows far into the future do little to enhance the rate of return, but loss of cash inflows in the near term can do much to reduce it. Therefore, Dr. Blue should be very concerned about any potential decrease in the life of the equipment, while at the same time realizing that any increase in the life of the equipment will do little to enhance her rate of return. 4. a. The expected annual cash inflow would be:

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P37,500 x 120% = P45,000 P142,950 P45,000

=

3.177

Reading along the 7-period line of the PV table, a factor of 3.177 is closest to 3.161, the factor for 25%, and is between that factor and the factor for 24%. Thus, to the nearest whole percent, the internal rate of return is 25%. b. The expected annual cash inflow would be: P37,500 x 80% = P30,000 P142,950 P30,000

=

4.765

Reading along the 7-period line of the PV table, a factor of 4.765 is closest to 4.712, the factor for 11%. Thus, to the nearest whole percent, the internal rate of return is 11%. Unlike changes in time, increases and decreases in cash flows at a given point in time have basically the same impact on the rate of return, as shown below:

5. Since the cash flows are not even over the five-year period (there is an extra P61,375 cash...