CHAPTER 25

PLANNING FOR CAPITAL INVESTMENTS

CHAPTER LEARNING OBJECTIVES

1. Describe capital budgeting inputs and apply the cash payback technique. Management gathers project proposals from each department; a capital budget committee screens the proposals and recommends worthy projects. Company officers decide which projects to fund, and the board of directors approves the capital budget. In capital budgeting, estimated cash inflows and outflows, rather than accrual-accounting numbers, are the preferred inputs.

The cash payback technique identifies the time period required to recover the cost of the investment. The equation when net annual cash flows are equal is: Cost of capital investment ÷ Estimated net annual cash flow = Cash payback period. The shorter the payback period, the more attractive the investment.

1. Use the net present value method. The net present value method compares the present value of future cash flows with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the project if net present value is negative.
2. Identify capital budgeting challenges and refinements. Intangible benefits are difficult to quantify and thus are often ignored in capital budgeting decisions. This can result in incorrectly rejecting some projects. One method for considering intangible benefits is to calculate the NPV, ignoring intangible benefits. If the resulting NPV is below zero, evaluate whether the benefits are worth at least the amount of the negative net present value. Alternatively, intangible benefits can be incorporated into the NPV calculation, using conservative estimates of their value.

The profitability index is a tool for comparing the relative merits of alternative capital investment opportunities. It is computed as Present value of net cash flows ÷ Initial investment. The higher the index, the more desirable the project.

A post-audit is an evaluation of a capital investment’s actual performance. Post-audits create an incentive for managers to make accurate estimates. Post-audits also are useful for determining whether a company should continue, expand, or terminate a project. Finally, post-audits provide feedback that is useful for improving estimation techniques.

1. Use the internal rate of return method. The objective of the internal rate of return method is to find the interest yield of the potential investment, which is expressed as a percentage rate. The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate of return.
2. Use the annual rate of return method. The annual rate of return uses accrual accounting data to indicate the profitability of a capital investment. It is calculated as Expected annual net income ÷ Amount of the average investment. The higher the rate of return, the more attractive the investment.

TRUE-FALSE STATEMENTS

1. Capital budgeting decisions usually involve large investments and often have significant impacts on a company's future profitability.

1. The capital budgeting committee ultimately approves the annual capital expenditure budget.

1. For purposes of capital budgeting, estimated cash inflows and cash outflows are the preferred inputs for capital budgeting decision tools.

1. The cash payback technique is a quick way to calculate a project's net present value.

1. The cash payback period is computed by dividing the cost of the capital investment by the net annual cash flow.

1. The cash payback method is frequently used as a screening tool but it does not take into consideration the profitability of a project.

1. The cost of capital is a weighted average of the rates paid on borrowed funds as well as on funds provided by investors in the company's stock.

1. When the net present value method is used, a net present value of zero indicates that the project would not be acceptable.

1. The net present value method can only be used in capital budgeting if the expected cash flows from a project are an equal amount each year.

1. If intangible benefits are not considered, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company.

1. To avoid accepting projects that actually should be rejected, a company should ignore intangible benefits in calculating net present value.

1. One way of incorporating intangible benefits into the capital budgeting decision is to project conservative estimates of the value of the intangible benefits and include them in the NPV calculation.

1. The profitability index is calculated by dividing a project’s total cash flows by its initial

investment.

1. The profitability index allows comparison of the relative desirability of projects that require differing initial investments.

1. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns.

1. A well-run organization should perform an evaluation, called a post-audit, of its investment projects before their completion.

1. Post-audits create an incentive for managers to make accurate estimates since managers know that their results will be evaluated.

1. A post-audit is an evaluation of how well a project's actual performance matches the projections made when the project was proposed.

1. The internal rate of return method is, like the NPV method, a discounted cash flow technique.

1. The interest yield of a project is a rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash flows.

1. Using the internal rate of return method, a project is rejected if its rate of return is greater than or equal to the required rate of return.

1. Using the annual rate of return method, a project is acceptable if its rate of return is greater than management's minimum rate of return.

1. The annual rate of return method requires dividing a project's annual cash flows by the economic life of the project.

1. A major advantage of the annual rate of return method is that it considers the time value of money.

1. An advantage of the annual rate of return method is that it relies on accrual accounting numbers rather than actual cash flows.

MULTIPLE CHOICE QUESTIONS

1. The annual capital budget is approved by a company's
   1. board of directors.
   2. capital budgeting committee.
   3. officers.
   4. stockholders.

1. All of the following groups are involved in the capital budgeting evaluation process except a company's
   1. board of directors.
   2. capital budgeting committee.
   3. officers.
   4. stockholders.

1. Most of the capital budgeting methods use
   1. accrual accounting numbers.
   2. cash flow numbers.
   3. net income.
   4. accrual accounting revenues.

1. The first step in the capital budgeting evaluation process is to
   1. request proposals for projects.
   2. screen proposals by a capital budgeting committee.
   3. determine which projects are worthy of funding.
   4. approve the capital budget.

1. The capital budgeting decision depends in part on the
   1. availability of funds.
   2. relationships among proposed projects.
   3. risk associated with a particular project.
   4. All of these answers are correct.

1. Capital budgeting is the process
   1. used in sell or process further decisions.
   2. of determining how much capital stock to issue.
   3. of making capital expenditure decisions.
   4. of eliminating unprofitable product lines.

1. Net annual cash flow can be estimated by
   1. deducting credit sales from net income.
   2. adding depreciation expense to net income.
   3. deducting credit purchases from net income.
   4. adding advertising expense to net income.

1. Which of the following is not a typical cash flow related to equipment purchase and replacement decisions? a. Operating costs
   1. Overhaul of equipment
   2. Salvage value of equipment when project is complete
   3. Depreciation expense

1. Capital expenditure proposals are initially screened by a company’s
   1. board of directors.
   2. executive committee.
   3. capital budgeting committee.
   4. stockholders.

1. Capital budgeting decisions depend in part on all of the following except the
   1. relationships among proposed projects.
   2. profitability of the company.
   3. company’s basic decision making approach.
   4. risks associated with a particular project.

1. All of the following are capital budgeting decisions except
   1. Replacing equipment
   2. Purchasing new equipment
   3. Scrapping old equipment that is no longer used
   4. All of these are capital budgeting decisions.

None, IMA: Investment Decisions

1. Which of the following is not a capital budgeting decision?
   1. Constructing new studios
   2. Replacing old equipment
   3. Scrapping obsolete inventory
   4. Remodeling an office building

None, IMA: Investment Decisions

1. Which of the following is a disadvantage of the cash payback technique?
   1. It is difficult to calculate
   2. It relies on the time value of money
   3. It can only be calculated when there are equal annual net cash flows
   4. It ignores the expected profitability of a project

None, IMA: Investment Decisions

1. The payback period is often compared to an asset’s
   1. estimated useful life.
   2. warranty period.
   3. net present value.
   4. internal rate of return.

None, IMA: Investment Decisions

1. Which of the following techniques ignores the time value of money?
   1. Internal rate of return
   2. Profitability index
   3. Net present value
   4. Cash payback

None, IMA: Investment Decisions

1. Brady Corp. is considering the purchase of a piece of equipment that costs $20,000. Projected net annual cash flows over the project’s life are:

Year Net Annual Cash Flow

• • • 1. $ 3,000
      2. 8,000
      3. 15,000
      4. 9,000

The cash payback period is a. 2.29 years.

• 1. 2.60 years.
  2. 2.40 years.
  3. 2.31 years.

PC: None, IMA: Investment Decisions

1. Bradshaw Inc. is contemplating a capital investment of $88,000. The cash flows over the project’s four years are:

The cash payback period is a. 3.59 years.

• 1. 3.50 years.
  2. 2.37 years.
  3. 3.20 years.

PC: None, IMA: Investment Decisions

1. Soldier Creek Corp. is considering the purchase of a piece of equipment and has compiled the following information

Initial cost $120,000

One-time training cost 15,000

Salvage value 20,000

Useful life 5 years

Projected net annual cash flows over the project’s life are:

Year Net Annual Cash Flow

• • • 1. $ 35,000
      2. 55,000
      3. 55,000
      4. 65,000
      5. 75,000

Soldier Creek uses the cash payback method as an initial screening tool and has a policy that the payback period should not be more than half of the asset’s useful life. Based on this, should Soldier Creek move forward with further evaluation of the equipment purchase?

• 1. No, because the cash payback period of 2.55 years is longer than half of the asset’s 5-year useful life.
  2. Yes, because the cash payback period of 2.36 years is less than half of the asset’s 5year useful life.
  3. No, because the cash payback 2.82 years is longer than half of the asset’s 5-year useful life.
  4. Yes, because the cash payback period of 2.82 years is less than the asset’s 5-year useful life of the asset.

PC: None, IMA: Investment Decisions

1. Sally Inc. is considering the purchase of a piece of equipment and has compiled the following information

Initial cost $200,000

One-time set-up fee 20,000

Salvage value 30,000

Useful life 6 years

Projected net annual cash flows over the project’s life are:

Year Net Annual Cash Flow

• • • 1. $60,000
      2. 80,000
      3. 80,000
      4. 70,000
      5. 70,000
      6. 60,000

Sally uses the cash payback method as an initial screening tool and has a policy that the payback period should not be more than half of the asset’s useful life. Based on this, should Sally move forward with further evaluation of the equipment purchase?

• 1. yes, because the cash payback period of 2.75 years is less than half of the asset’s 6year useful life .
  2. No, because the cash payback period of 3.14 years is longer than half of the asset’s 6-year useful life.
  3. Yes, because the cash payback period of 3 years is less than the asset’s 6-year useful life.
  4. Yes, because the cash payback period is equal to half of the asset’s 6-year useful life of the asset.

1. Jordan Company is considering the purchase of a machine and has compiled the following data:

The asset’s cash payback period is a. 2.70 years.

• 1. 2.50 years.
  2. 2.37 years.
  3. 2.17 years.

PC: None, IMA: Investment Decisions

Ex. 177

Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin Beagle, production manager, is considering purchasing a machine that will make the corn dogs. Austin has shopped for machines and found that the machine he wants will cost $215,000. In addition, Austin estimates that the new machine will increase the company’s annual net cash flows by $33,000. The machine will have a 12-year useful life and no salvage value.

Instructions

1. Calculate the cash payback period.
2. Calculate the machine’s internal rate of return.
3. Calculate the machine’s net present value using a discount rate of 10%.
4. Assuming Corn Doggy, Inc.’s cost of capital is 10%, is the investment acceptable? Why or why not?

Interpretation, AICPA PC: None, IMA: Investment Decisions

Ex. 179

Gantner Company is considering a capital investment of $300,000 in additional productive facilities. The new machinery is expected to have a useful life of 5 years with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash flows are expected to be $27,000 and $87,000, respectively. Gantner has a 12% cost of capital rate, which is the minimum acceptable rate of return on the investment.

Instructions

(Round to two decimals.)

1. Compute (1) the annual rate of return and (2) the cash payback period on the proposed capital expenditure.
2. Using the discounted cash flow technique, compute the net present value.

AICPA PC: None, IMA: Investment Decisions

Ex. 181

Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has provided him valuable knowledge of the sport, and he is thinking about going into the batting cage business. He estimates the construction of a state-of-the-art building and the purchase of necessary equipment will cost $840,000. Both the facility and the equipment will be depreciated over 12 years using the straight-line method and are expected to have zero salvage values. His required rate of return is 9% (present value factor of 7.1607). Estimated annual net income is as follows:

Instructions

For this investment, calculate:

1. The net present value.
2. The internal rate of return.
3. The cash payback period.

AICPA PC: None, IMA: Investment Decisions

Ex. 183

Savanna Company is considering two capital investment proposals. Relevant data on each project are as follows:

Depreciation is computed by the straight-line method with no salvage value. Savanna requires an 8% rate of return on all new investments. The present value of 1 for 8 periods at 8% is .540 and the present value of an annuity of 1 for 8 periods is 5.747.

Instructions

1. Compute the cash payback period for each project.
2. Compute the net present value for each project.
3. Compute the annual rate of return for each project.
4. Which project should Savanna select?

AICPA PC: None, IMA: Investment Decisions

Ex. 184

Yappy Company is considering a capital investment of $320,000 in additional equipment. The new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash flows are expected to be $22,000 and $62,000, respectively. Yappy requires a 10% return on all new investments.

Present Value of an Annuity of 1

Period 8% 9% 10% 11% 12% 15%

8 5.747 5.535 5.335 5.146 4.968 4.487

Instructions

1. Compute each of the following:
   1. Cash payback period.
   2. Net present value.
   3. Profitability index.
   4. Internal rate of return.
   5. Annual rate of return.
2. Indicate whether the investment should be accepted or rejected.

Interpretation, AICPA PC: None, IMA: Investment Decisions

Ex. 185

Laramie Service Center just purchased an automobile hoist for $16,900. The hoist has a 5-year life and an estimated salvage value of $1,250. Installation costs were $3,770, and freight charges were $960. Laramie uses straight-line depreciation.

The new hoist will be used to replace mufflers on automobiles. Laramie estimates that the new hoist will enable his mechanics to replace four extra mufflers per week. Each muffler sells for $85 installed. The cost of a muffler is $46, and the labor cost to install a muffler is $13.

Instructions

1. Compute the payback period for the new hoist.
2. Compute the annual rate of return for the new hoist. (Round to one decimal.)

AICPA PC: None, IMA: Investment Decisions

Ex. 192

Shilling Corp. is thinking about opening a baseball camp in Florida. In order to start the camp, the company would need to purchase land, build five baseball fields, and a dormitory-type sleeping with a dining facility to house 100 players. Each year the camp would be run for 10 sessions of 1 week each. The company would hire college baseball players as coaches. The camp attendees would be baseball players age 12-18. Property values in Florida have enjoyed a steady increase in value. It is expected that after using the facility for 20 years, Shilling can sell the property for more than the amount for which it was originally purchased. The following amounts have been estimated:

Instructions

1. Calculate the net present value of the project.
2. To gauge the sensitivity of the project to these estimates, assume that if only 80 campers attend each week, revenues will be $2,085,000 and expenses will be $1,865,000. What is the net present value using these alternative estimates? Discuss your findings.
3. Assuming the original facts, what is the net present value if the project is actually riskier than first assumed, and a 12% discount rate is more appropriate? The present value of 1 at 12% is .104 and the present value of an annuity of 1 is 7.469.

AICPA PC: None, IMA: Investment Decisions

Ex. 193

Ace Corporation recently purchased a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $250,000 in annual cash flows for a period of five years. The required rate of return is 8%. The new machine is expected to have zero salvage value at the end of the five-year period.

Instructions

Calculate the internal rate of return. (Table 4 from Appendix C is needed.)

AICPA PC: None, IMA: Investment Decisions