Chapter 12 Discussion Questions 12-1 What are the important administrative considerations in the capital budgeting Important administrative considerations relate to the search for and discovery of investment opportunities, the collection of data, the evaluation of projects d the reevaluation of prior d 12-2 Why does capital bud geting rely on analysis of cash flows rather than on net income? Cash flow rather than net income is used in capital budgeting analysis becaus the primary concern is with the amount of actual dollars generated For example, depreciation is subtracted out in arriving at net income, but this noncash deduction should be ad ded back in to determine cash flow or actual dollars generated What are the weaknesses of the pay back method? The weaknesses of the payback method are b. The concept fails to consider the time value of money od a. There is no consideration of inflows after the cutoff per 12-4 What is normally used as the d iscount rate in the net present value method? The cost of capital as determined in Chapter 11 12-5 What does the term mutually exclusive investments mean? The selection of one investment precludes the selection of other alternative Investments 12-6 How does the modified internal rate of return include concepts from both the trad itional internal rate and the net present value methods? The mod ified internal ratio of return calls for the determination of the interest rate that equates future inflows to the investment as does the trad itional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of
Chapter 12 Discussion Questions 12-1. What are the important administrative considerations in the capital budgeting process? Important administrative considerations relate to: the search for and discovery of investment opportunities, the collection of data, the evaluation of projects, and the reevaluation of prior decisions. 12-2. Why does capital budgeting rely on analysis of cash flows rather than on net income? Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, depreciation is subtracted out in arriving at net income, but this noncash deduction should be added back in to determine cash flow or actual dollars generated. 12-3. What are the weaknesses of the payback method? The weaknesses of the payback method are: a. There is no consideration of inflows after the cutoff period. b. The concept fails to consider the time value of money. 12-4. What is normally used as the discount rate in the net present value method? The cost of capital as determined in Chapter 11. 12-5. What does the term mutually exclusive investments mean? The selection of one investment precludes the selection of other alternative investments. 12-6. How does the modified internal rate of return include concepts from both the traditional internal rate and the net present value methods? The modified internal ratio of return calls for the determination of the interest rate that equates future inflows to the investment as does the traditional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of capital
If a corporation has projects that will earn more than the cost of capital, should it ration capital? From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find add itional funds and increases its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost 12-8 What is the net present value profile? What three points should be determined to graph the profile? The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis The points that must be determined to graph the profile are a. The net present value at zero discount rate b. The net present value as determined by a normal discount rate c. The internal rate of return for the investment How does an asset's ADr (asset depreciation range)relate to its mACRS The ADR represents the asset depreciation range or the expected physical life of the asset generally the midpoint of the range or life is utilized The longer the adr midpoint, the longer the MACrS category in which the asset is placed. However, most assets can still be written off more rapidly than the midpoint of the ADR. For example, assets with ADR midpoints of 10 yea 15 years can be placed in the 7-year MACRS category for depreciation s to purpos CopyrightC 2005 by The McGray-Hill Companies, Inc. S-422
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-422 12-7. If a corporation has projects that will earn more than the cost of capital, should it ration capital? From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increases its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost. 12-8. What is the net present value profile? What three points should be determined to graph the profile? The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis. The points that must be determined to graph the profile are: a. The net present value at zero discount rate. b. The net present value as determined by a normal discount rate. c. The internal rate of return for the investment. 12-9. How does an asset's ADR (asset depreciation range) relate to its MACRS category? The ADR represents the asset depreciation range or the expected physical life of the asset. Generally, the midpoint of the range or life is utilized. The longer the ADR midpoint, the longer the MACRS category in which the asset is placed. However, most assets can still be written off more rapidly than the midpoint of the ADR. For example, assets with ADR midpoints of 10 years to 15 years can be placed in the 7-year MACRS category for depreciation purposes
Problems Assume a corporation has earnings before depreciation and taxes of $90,000, and depreciation of $40,000, and that it has a 30 percent tax bracket Compute its cash flow using the format below Earnings before depreciation and taxes Earnings before taxes Earnings after taxes Depreciation Cash flow Solution: Earnings before depreciation and taxes $90000 Depreciation 40000 Earnings before taxes 50.000 Taxes(@ 30% 15000 Ear fter taxes $35,000 Depreciation 40.000 Cash flow $75000 S-423 oyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-423 Problems 12-1. Assume a corporation has earnings before depreciation and taxes of $90,000, and depreciation of $40,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below. Earnings before depreciation and taxes Depreciation Earnings before taxes Taxes @ 30% Earnings after taxes Depreciation Cash flow Solution: 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 a. In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same b. How much cash flow is lost due to the reduced depreciation between problems I and 2a? Solution: a. Earnings before depreciation and taxes $90000 Depreciation 10000 Earnings before taxes $80000 Taxes@ 30% 24000 Earnings after taxes $56.000 Depreciation +10000 Cash flow $66.000 b Cash flow(problem 1) $75.000 Cash flow(problem 2) 66.000 Difference in cash flow $9,000 CopyrightC 2005 by The McGray-Hill Companies, Inc. S-424
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-424 12-2. a. In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same. b. How much cash flow is lost due to the reduced depreciation between problems 1 and 2a? Solution: a. Earnings before depreciation and taxes $90,000 Depreciation –10,000 Earnings before taxes $80,000 Taxes @ 30% –24,000 Earnings after taxes $56,000 Depreciation +10,000 Cash flow $66,000 b. Cash flow (problem 1) $75,000 Cash flow (problem 2) 66,000 Difference in cash flow $ 9,000
Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket a. Compute its cash flow. b. Assume it has $200,000 in depreciation Recompute its cash flow c. How large a cash flow benefit d id the depreciation provide? d. Would the president of a firm on the New York Stock Exchange likely be satisfied with the earnings after taxes results in part c? Solution: a. Earnings before depreciation and taxes $200000 Depreciation 0 Earnings before taxes 200.000 xes 40% 80000 Earnings after taxes 120.000 Depreciation 0 Cash flow $120,000 b. Earnings before depreciation and taxes $200000 Depreciation 200000 Earnings before taxes Taxes@ 40% Earnings after taxes 000 Depreciation 200000 Cash flow $200000 S-425 oyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-425 12-3. Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket. a. Compute its cash flow. b. Assume it has $200,000 in depreciation. Recompute its cash flow. c. How large a cash flow benefit did the depreciation provide? d. Would the president of a firm on the New York Stock Exchange likely be satisfied with the earnings after taxes results in part c? 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 Depreciation – 0 Cash flow $120,000 b. Earnings before depreciation and taxes $200,000 Depreciation –200,000 Earnings before taxes 0 Taxes @ 40% 0 Earnings after taxes 0 Depreciation 200,000 Cash flow $200,000
12-3. Continued c. The $200,000 in depreciation provided a cash flow benefit of $80,000 Cash flow(b) $200.000 Cash flow(a) 120.000 Cash flow benefit $80,000 d. The president of a New York Stock Exchange firm might not be satisfied by the results provided by depreciation. Although depreciation increased cash flow by $80,000, it decreased earnings after taxes by $120,000 down to zero. CEOs tend to be very sensitive to earnings performance. Although this is not necessarily rational, it is likely to be true Assume a $40,000 investment and the following cash flows for two alternatives Investment X Investment y 112345 $6,000 $15,000 8.000 20.000 9.000 10,000 17,000 000 Which of the alternatives would you select under the pay back method? Solution: Payback for Investment X Payback for Investment Y $40000-$60001year $40000-$150001year 34,000-8,0002 years 25.000-20.000 26,000-90003 years 5000/10,0005 years 17,000-17,0004 years Payback Investment X=4.00 years Payback Investment Y=2.50 years Investment Y would be selected because of the faster payback CopyrightC 2005 by The McGray-Hill Companies, Inc. S-426
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-426 12-3. Continued c. The $200,000 in depreciation provided a cash flow benefit of $80,000. Cash flow (b) $200,000 Cash flow (a) 120,000 Cash flow benefit $ 80,000 d. The president of a New York Stock Exchange firm might not be satisfied by the results provided by depreciation. Although depreciation increased cash flow by $80,000, it decreased earnings after taxes by $120,000 down to zero. CEOs tend to be very sensitive to earnings performance. Although this is not necessarily rational, it is likely to be true. 12-4. 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? 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 26,000 – 9,000 3 years 5,000/10,000 .5 years 17,000 – 17,000 4 years Payback Investment X = 4.00 years Payback Investment Y = 2.50 years Investment Y would be selected because of the faster payback
Referring back to problem 4, if the inflow in the fifth year for investment X were $20,000,000 instead of $20,000, would your answer change under the payback Solution: The $20,000,000 inflow would still leave the pay back period for Investment X at 4 years. It would remain inferior to Investment Y under the pay back method 12-6 The Short-Line Railroad is considering a $100,000 investment in either of two companies. The cash flows are as follows Year Electric Co. Water Works 70,000 $l5,000 2 15,000 70.000 4-10 10.000 10.000 Using the payback method, what will the decision be? Explain why the answer in part a can be mislead ing Solution: Short-Line railroad a Payback for Electric Co Payback for Water Works $100,000-$70,0001 $100000-$150001 30,000-15,0002 years 85000-15,0002 years 15000-15.0003 years 70,000-70,0003 years Payback(Electric Co. )=3 years Payback(Water Works)=3 years S-427 Copyright o 2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-427 12-5. Referring back to problem 4, if the inflow in the fifth year for investment X were $20,000,000 instead of $20,000, would your answer change under the payback method? Solution: The $20,000,000 inflow would still leave the payback period for Investment X at 4 years. It would remain inferior to Investment Y under the payback method. 12-6. The Short-Line Railroad is considering a $100,000 investment in either of two companies. The cash flows are as follows: Year Electric Co. Water Works 1 ............ $70,000 $15,000 2 ............ 15,000 15,000 3 ............ 15,000 70,000 4-10 ....... 10,000 10,000 a. Using the payback method, what will the decision be? b. Explain why the answer in part a can be misleading. Solution: Short-Line Railroad a. Payback for Electric Co. Payback for Water Works $100,000 – $70,000 1 year $100,000 – $15,000 1 year 30,000 – 15,000 2 years 85,000 – 15,000 2 years 15,000 – 15,000 3 years 70,000 – 70,000 3 years Payback (Electric Co.) = 3 years Payback (Water Works) = 3 years
12-6. Continued b. The answer in part a is misleading because the two investments seem to be equal with the same pay back period of three year Nevertheless, the Electric Co. is a superior investment because it recovers large cash flows in the first year, while the large recovery for Water Works is not until the third year. The problem is that the pay back method does not consider the time value of money 12-7 X-treme Vitamin Company is considering two investments, both of which cost $10.000. The cash flows are as follows eal Project A Project B $12,000 $10,000 800 6,000 6,000 16000 a. Which of the two projects should be chosen based on the payback method? b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 perce Should a firm normally have more confidence in answer a or answer b? Solution: X-treme Vitamin Company a. pay back Method Pay back for project A 10.000 = 83 years 12000 Payback for Project B 10,000 =l year 10,000 Under the pay back Method you should select Project a because of the shorter pay back period CopyrightC 2005 by The McGray-Hill Companies, Inc. S-428
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-428 12-6. Continued b. The answer in part a is misleading because the two investments seem to be equal with the same payback period of three year. Nevertheless, the Electric Co. is a superior investment because it recovers large cash flows in the first year, while the large recovery for Water Works is not until the third year. The problem is that the payback method does not consider the time value of money. 12-7. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows: Year Project A Project B 1 $12,000 $10,000 2 8,000 6,000 3 6,000 16,000 a. Which of the two projects should be chosen based on the payback method? b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent. c. Should a firm normally have more confidence in answer a or answer b? Solution: X-treme Vitamin Company a. Payback Method Payback for Project A .83 years 12,000 10,000 = Payback for Project B 1 year 10,000 10,000 = Under the Payback Method, you should select Project A because of the shorter payback period
12-7. Continued b. Net Present Value Method Project A Year Cash Flow PVIF at 10% Present value $12000 909 $10908 2$8.000 826 $6,608 3$6,000 751 4506 Present Value of Inflows $22022 Present Value of outflows 10.000 Net present value $12022 Project B Year Cash Flow PVIe at 10% Present Value $10000 09 9090 2$6000 826 $4,956 3$16000 751 $12016 Present Value of inflows $26.062 Present Value of outflows 10000 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 pay back method S-429 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-429 12-7. Continued b. Net Present Value Method Project A Year Cash Flow PVIF at 10% Present Value 1 $12,000 .909 $10,908 2 $ 8,000 .826 $ 6,608 3 $ 6,000 .751 $ 4,506 Present Value of Inflows $22,022 Present Value of Outflows 10,000 Net Present Value $12,022 Project B Year Cash Flow PVIF at 10% 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
12-8 You buy a new piece of equipment for $16, 980, and you receive a cash inflow of $3, 000 per year for 12 years. What is the internal rate of return? Solution: Appendix D $16980 PVIEA =5.660 IRR 14% For n=12. we find 5.660 under the 14% column Warner Business Products is considering the purchase of a new machine at a cost of$11,070. The machine will provide $2,000 per year in cash flow for eight years. Warner's cost of capital is 13 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be Solution: Warner business products Appendix d PⅤIFA=$11,070/$2,000=5535 IRR 9% For n =8. we find 5,353 under the 9% column The machine should not be purchased since its return is under 13 percei CopyrightC 2005 by The McGray-Hill Companies, Inc. S-430
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-430 12-8. You buy a new piece of equipment for $16,980, and you receive a cash inflow of $3,000 per year for 12 years. What is the internal rate of return? Solution: Appendix D PVIFA = 5.660 $3,000 $16,980 = IRR = 14% For n = 12, we find 5.660 under the 14% column. 12-9. Warner Business Products is considering the purchase of a new machine at a cost of $11,070. The machine will provide $2,000 per year in cash flow for eight years. Warner’s cost of capital is 13 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken. Solution: Warner Business Products Appendix D PVIFA = $11,070/$2,000 = 5.535 IRR = 9% For n = 8, we find 5.353 under the 9% column. The machine should not be purchased since its return is under 13 percent
