LEARNING OBJECTIVES

Chapter 12Strategic Investment Decisions

LEARNING OBJECTIVES

Chapter 12 addresses the following questions:

Q1 How are strategic investment decisions made?Q2 What cash flows are relevant for strategic investment decisions?Q3 How is net present value (NPV) analysis performed and interpreted?Q4 What are the uncertainties and limitations of NPV analysis?Q5 What alternative methods (IRR, payback, and accrual accounting rate of return) are used

for strategic investment decisions?Q6 What additional issues should be considered for strategic investment decisions?Q7 How do income taxes affect strategic investment decision cash flows?Q8 How are the real and nominal methods used to address inflation in an NPV analysis?

(Appendix 12A)

These learning questions (Q1 through Q8) are cross-referenced in the textbook to individual exercises and problems.

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems.

Questions Having a Single Correct Answer:No Symbol This question requires students to recall or apply knowledge as shown in the

textbook.e This question requires students to extend knowledge beyond the applications

shown in the textbook.

Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):

Step 1 skills (Identifying) Step 2 skills (Exploring) Step 3 skills (Prioritizing) Step 4 skills (Envisioning)

12-2 Cost Management

QUESTIONS

12.1 After a number of years, the present value factors for all discount rates become quite small, and the incremental affect of future cash flows is therefore small. According to the present value tables, after about 15 years, the incremental values at rates above 8 to 10% are small (less than 20% of the original value). If these cash flows are small, but include error, the size of error would also be small and likely have little effect on the overall analysis.

12.2 If several projects are being analyzed, their NPVs can be summed to determine the NPV for that group or portfolio of projects, whereas IRR can be neither summed nor averaged. In addition, NPV provides information about the value of the projects in terms of today’s dollars. If projects are of different sizes, requiring large and small investments, NPV reflects these differences. IRR provides only a rate of return, and comparing rates of return does not take into consideration the size of return. In addition, the net present value method is computationally simpler than the internal rate of return method. Determining IRR can be time consuming, particularly for projects having uneven cash flows. However, the use of a spreadsheet reduces the effort considerably.

An important difference between the two methods is that the IRR method assumes cash inflows can be reinvested to earn the same return that the project would generate. However, it may be difficult for an organization to identify other opportunities that could achieve the same rate when IRR is high. In contrast, the NPV method assumes that cash inflows can be reinvested and earn the discount rate—a more realistic assumption. If the discount rate is set equal to the organization’s cost of capital, then alternative uses of cash would include paying off creditors or buying back stock. Therefore, if the results of analyses using the two methods are not the same, the NPV method is preferable.

Both methods are used widely in business. One reason for the continued use of IRR is that many people find it intuitively easier to understand than NPV. In addition, managers may want to compare the IRR on prior projects to current project return rates as they consider new investment.

12.3(a) Net present value (NPV)

Pros: NPV is more accurate than the payback and accrual accounting rate of return

methods because it reflects the time value of money. Under NPV, discounted cash flows reflect today’s dollars, so several different

projects can be easily compared to determine the one with the highest NPV.

Cons: It is sometimes more difficult to estimate cash flows and choose an

appropriate discount rate for NPV than finding the internal rate of return or calculating payback or an accounting rate of return.

Chapter 12: Strategic Investment Decisions 12-3

(b) Internal Rate of Return (IRR)Pros:

Many managers find IRR intuitively easier to understand than NPV IRR has the same advantage as NPV of including the time value of money. IRR can be used to compare potential projects (choose the one with highest

IRR).

Cons: Assumes cash flows can be reinvested at the IRR When comparing projects, IRR does not take into consideration size of

investment and may be inappropriate when managers need to choose among competing projects because capital is constrained.

IRRs from several projects cannot be summed or averaged, while net present values can.

IRR is computationally more difficult than NPV and the other methods, particularly with uneven cash flows.

(c) Payback MethodPros:

Used extensively, particularly outside of the U.S. Focuses on high risk of long payback period

Cons: Does not incorporate time value of money Ignores cash flows received after the investment is recovered

(d) Accrual Accounting Rate of ReturnPros:

Use for division or department performance because data is readily available

Cons Cost of investment is double-counted (depreciation is included in the

numerator, and the investment is the denominator) Not appropriate for capital budget decisions because it does not include the

time value of money

12.4 Estimating future cash flows becomes more difficult over longer periods of time because the uncertainties increase. Changes in economic, political, and consumer tastes that affect cash flows cannot be easily predicted. More information is usually available about near-term economic factors than long-term.

12.5 Future cash flows are discounted with present value factors that become increasingly small across time to reflect the fact that investors forego interest on cash flows that are received in the future relative to cash flows that are received today and could be invested today. This discounting reflects the opportunity cost (interest foregone) when money is received in the future instead of today.


12.6 A nominal discount rate includes a factor for inflation, and the real rate does not. Both rates include a risk-free rate and a risk premium. Using a nominal approach, different cash flows can be inflated differentially. For example, gasoline prices might inflate at a different rate than wages. If different types of cash flows are differentially inflated to better reflect future expectations, the preciseness of the estimation and analysis process increases and information quality increases.

12.7 Real assets tend to increase in nominal value under inflation, while monetary assets tend to remain fixed. If a firm has cash in a bank earning interest, the after-tax return could be less than the inflation rate. Therefore the firm’s cash would be losing purchasing power over time. In this case it would be better for the firm to invest in a real asset that increases at the inflation rate or greater.

12.8 Net present value. All investments with a positive net present value would be accepted, assuming that the cost of capital is constant across investments.

12.9 Requiring a higher return rate for projects in developing countries may be the firm's way of coping with increased problems of uncertainty and risk. Less developed countries usually have less stable political systems, economies, inflation rates, and consumer markets. In addition, infrastructure such as roads and utilities is sometimes unreliable, so production and transportation problems could occur more frequently. These factors increase the risk of doing business in developing countries.

From the host government's point of view, if a higher rate of return is not permitted under such circumstances, the investment would probably never have been made at all, and the developing country would be worse off as a result. The firm, however, must be careful to avoid any perception of exploitation, as the long-term reputation effect could be devastating.

12.10 There are two reasons to incorporate tax effects more formally into NPV analyses. From an accounting standpoint, tax regulations permit a shift of both the amount and the timing (sometimes permanently) of taxes; this will have an effect on present values. If tax savings based on current tax rules are not incorporated into the analysis, these effects are not captured and the analysis is less accurate. From a mathematical standpoint, the factors in the tables are not linearly related (all of the formulas have exponents); e.g., the present value factor for 20% is not one-half of the factor for 10%.

12.11 The return on the investment portfolio represents the clinic's opportunity cost for funds. They can earn at least that return; therefore, any other investment must yield a higher return.


EXERCISES

12.12 Time Value of Money

A. Using tables, the answer is ($8,000 x 0.583) = $4,664.Using Excel, the answer is $4,667.92.

B. Using the tables, the answer is ($125 x 1.791) = $223.88.Using Excel, the answer is $223.86.

C. Using tables, the answer is ($10,000 x 0.747) = $7,470.Using Excel, the answer is $7,472.58.

D. Using tables, the answer is ($1,000 x 0.507) = $507.Using Excel, the answer is $506.63.

12.13 Capital Budgeting Process

The proper sequence is: 4, 1, 5, 2, 3, and 6.

12.14 Overnight Laundry

Cash Flow Timeline:Time 0 Years1-10 Year 10

Investment $(96,000)Incremental cash flows:

Annual Savings $25,000Taxes (5,128) (a)

Net cash flow $19,872Terminal value $6,000

(a) The salvage value is ignored for income tax depreciation, so the annual depreciation = $96,000/10 years = $9,600 per year

Taxes per year = ($25,000 - $9,600) * 33.3% = $5,128

NPV calculation:

NPV = $(96,000) + $19,872 (PVFA 18%, 10 years) + $6,000 (PVF 18%, 10 years)= $(96,000) + ($19,872 x 4.494) + ($6,000 x0.191)= $(96,000) + $89,305 + $1,146= ($5,549)


12.15 Axel Corporaton

The net present value is $30,000 (5.019) - 150,000 = $570.

The internal rate of return is a little higher than 15%. Using Excel, the actual rate is 15.098%.

12.16 Amaro Hospital

A. The net present value is ($5,000 x 5.216) - 20,000 = $6,080

B. The factor for the internal rate of return must be20,000 = $5,000*FactorFactor = 4.0

From the PVFA tables for 10 year, it would be just over 20% (PVFA = 4.192)

Using Excel’s IRR function, the rate is 21.4%

C. Assuming straight-line depreciation, the earnings will be

$5,000 - $20,000/10 = $3,000

The accounting rate of return is $3,000/20,000 = 15%

D. The payback period is $20,000/$5,000 = 4

12.17 Crown Corporation

A. The PVFA for four payments discounted at 6% is 3.465. Thus, the present value of the note is $1,000 x 3.465 = $3,465. With the down payment, the total is $4,465.

B. Because this is a single payment the factor is a present value single amount of 0.735, so the total is $4,000 x .735 = $2,940. With the down payment it becomes a total present value selling price of $3,940.

C. The selling price of the equipment is $5,000 no matter how the employee gets the cash and what Crown does with the $5,000. The future value factor for three years hence is 1.225, yielding: $5,000 x 1.225 = $6,125.


12.18 Clearwater Bottling Company

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg).

A.Cash Flow Timeline:

Time 0 Years1-5 Year 10Investment $(100,000)Incremental cash flows:

Annual Savings $20,000 (a)Taxes (0) (b)

Net cash flow $20,000Terminal value $0

(a) Savings = Additional contribution margin – Increase in fixed costs = ($9 - $7) x 20,000 cases - $20,000 = $20,000

(b) Depreciation = $100,000/5 years = $20,000 per yearIncremental Taxes = (Savings – Depreciation) * 25%

= ($20,000 - $20,000) * 25% = $0

B. The NPV for this part can easily be calculated manually as shown below. The sample spreadsheet shows the NPV to be $(27,904). The difference is due to rounding.

NPV = $(100,000) + $20,000 (PVFA 12%, 5 years)NPV = $(100,000) + $20,000 x 3.605NPV = $(27,900)

C. To determine the amount of sales needed to bring the NPV to zero, first re-write the incremental cash flows substituting Q for the volume of cases sold.

Cash Flow Timeline:Time 0 Years1-5 Year 10


Annual contribution margin $2Q (a)Incremental fixed costs (20,000)Incremental taxes ($0.5Q - $5,000) (b)

Net cash flow $1.5Q - $15,000Terminal value $0

(a) Annual contribution margin per case (Q) = ($9 - $7)Q = $2Q(b) Depreciation = $100,000/5 years = $20,000 per year

Incremental Taxes = ($2Q – $20,000) * 25%= $0.5Q - $5,000


Next, set the NPV equal to zero and solve for Q:

0 = $(100,000) + ($1.5Q - $5,000) x 3.605= = $(100,000) + 5.4075Q - $18,0255.4075Q = $118,025Q = 21,826 cases

D. Below is an excerpt from the sample spreadsheet showing calculations using the nominal method:


Below is an excerpt from the sample spreadsheet showing calculations using the real method:

12.19 Parish County

This problem is most easily solved in steps. First determine the present value of the terminal cash flow:

Terminal value = $400,000 x 20% = $80,000Present value = $80,000 x (PVF, 10%, 5 years) = $80,000 x 0.621 = $49,680

Subtract the present value of the terminal value from the investment to determine the present value needed from annual savings to justify the purchase:

Minimum PV of annual savings = $400,000 - $49,680 = $350,320


Finally, determine the annual savings needed to achieve the present value calculated above. The following calculation assumes that the annual savings would be identical during each of the 5 years.

Savings x (PVFA, 10%, 5 years) = $350,320Savings x 3.791 = $350,320Savings = $350,320/3.791 = $92,408

The company must generate at least $92,408 per year in savings to justify purchasing the plane.

12.20 Equipment Investment

A.Time 0 investment = -$60,000Years 1-6: Year

1 2 3 4 5 6Annual saving $18,000 $18,000 $18,000 $18,000 $18,000 $18,000Depreciation 4,000 4,000 4,000 4,000 4,000 4,000Total annual after-tax flows $22,000 $22,000 $22,000 $22,000 $22,000 $22,000

Calculation details:Annual after-tax savings = $30,000 * (1-0.40) = $18,000Straight-line depreciation = $60,000/6 years = $10,000 per yearDepreciation tax savings per year = $10,000 * 0.40 = $4,000

NPV calculation:NPV = -$60,000 + $22,000 x (PVFA 10% 6 years)NPV = -$60,000 + $22,000 x 4.355 = $35,810

C. To determine the payback period, first summarize the cumulative cash flows from the project:

Year Cumulative Cash Inflows1 22,0002 44,0003 66,000

The original investment is $60,000, which is expected to be paid back between 2 and 3 years. If the cash flows are assumed to occur evenly throughout each year, the payback period is 2.73 years [(2 + (60,000 - 44,000)/22,000)]. Because cash flows are identical across years, the payback can also be calculated as follows: $60,000/$22,000 = 2.73 years.


12.21 Ferris Industries


A. Internal rates of return were calculated using the Excel function IRR. The rates of return are

Project IRR1 15.67%2 27.32%3 26.59%4 28.14%

Based solely on the internal rate of return, the projects would be ranked 4, 2, 3, and 1.

B. There appear to be considerable differences in risk among the projects. Projects 2 and 3 expect negative incremental operating cash flows during some of the years, and project 4 expects zero incremental operating cash flows during 2 of the 6 years. Projects 2, 3, and 4 show more variation across years than project 1. If there is a high rate of technological change in this industry, management may prefer project 2, which pays back most of the investment quickly.

12.22 Lymbo Company, Inc.

A. Based on the NPV of the two alternatives, the company should choose Alternative 2 with a less negative NPV than Alternative 1. Calculations for each alternative are shown below.

Cash Flow Timeline for Alternative 1:Time 0 Years 1-5 Years 6-15


Maintenance Cost $(20,000) $(20,000)Taxes 12,000 (a) 6,000 (b)

Net cash flow $ (8,000 ) $(14,000)

(a) Depreciation = $100,000/5 years = $20,000 per yearIncremental taxes deductions during years 1-5 = (Maintenance cost +

Depreciation) * 30%= ($20,000 + $20,000) * 30% = $12,000

(b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%= $20,000 * 30% = $6,000


NPV Calculation for Alternative 1:

NPV = $(100,000) + [$(8,000) x (PVFA 12%, 5 years)] + [$(14,000) x (PVFA 12% 15 years – PVFA 12% 5 years)]

NPV = $(100,000) + [$(8,000) x 3.605] + [$(14,000) x (6.811 – 3.605]NPV = $(100,000) + $(28,840) + $(44,884) = $(173,724)

Following is a different way to perform the same calculations for Alternative 1:

NPV of installation cost $(100,000)NPV of annual maintenance cost

$(20,000) x (1-30%) x 6.811 (95,354)NPV of depreciation tax shield

$20,000 x 30% x 3.605 21,630Total NPV $(173,724)

Cash Flow Timeline for Alternative 2:

Time 0 Years 1-5 Years 6-15Investment $(150,000)Incremental cash flows:

Maintenance Cost $(10,000) $(10,000)Taxes 12,000 (a) 3,000 (b)

Net cash flow $ 2,000 $ (7,000)

(a) Depreciation = $150,000/5 years = $30,000 per yearIncremental taxes deductions during years 1-5 = (Maintenance cost +

Depreciation) * 30%= ($10,000 + $30,000) * 30% = $12,000

(b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30%= $10,000 * 30% = $3,000

NPV Calculation for Alternative 2:

NPV = $(150,000) +[ $2,000 x (PVFA 12%, 5 years)] + [$(7,000) x (PVFA 12% 15 years – PVFA 12% 5 years)]

NPV = $(150,000) + [$2,000 x 3.605] + [$(7,000) x (6.811 – 3.605)]NPV = $(150,000) + $7,210 + $(22,442) = $(165,232)

Following is a different way to perform the same calculations for Alternative 2:


$(10,000) x (1-30%) x 6.811 (47,677)NPV of depreciation tax shield

$30,000 x 30% x 3.605 32,445Total NPV $(165,232)


B. Following are the NPV calculations without the depreciation tax shield:

NPV without income taxes for Alternative 1:


$(20,000) x 6.811 (136,220)Total NPV $(236,220)

NPV without income taxes for Alternative 2:


$(10,000) x 6.811 (68,110)Total NPV $(218,110)

The answer depends on management's time-frame used in the budget process. If the not-for-profit organization intends to occupy the building for the next 15 years, alternative 2 is still the best choice. However, management may concern itself only with current year outlays (a focus of many governmental units). In that case, alternative 1 might be chosen because its initial cost is $50,000 less than alternative 2's. Although this is a common approach, one might question whether it is "proper."

12.23 Garco

A.Present Value Present

Factor ValueInitial net investment (1,000,000 - 60,000) 1.00 $ (940,000)Annual savings 300,000 3.605 1,081,500

Net present value $ 141,500

B. First calculate the present value factor for an annuity of 5 payments that equates the cash inflows and outflows:

$300,000 * F = 940,000F = 3.13333

A factor of 3.13333 represents an internal rate of return of slightly less than 18%.

A spreadsheet could be used to determine the exact answer of 17.913%.

C. Assuming the cash flows take place evenly throughout the year:$940,000/$300,000 = 3.13 years


PROBLEMS

12.24 Jackson

[Note about problem complexity: Item B is not coded as Step 3 because this is explicitly discussed in the chapter.]

A. The choices are (1) hold the stock and work for $90,000 per year or (2) sell the stock, do not take the job, and start the restaurant. This is a long-term decision.

B. Either IRR or NPV methods could be used for this analysis. The decision is a long-term decision and therefore needs to include the time value of money. Both of these methods do that. With the NPV method, inflation rates for different categories of costs could be used, so the results would be more precise. In addition, it may be easier to understand the differences in these two plans in today’s dollars, rather than in rates of returns.

C. His opportunity costs are $90,000 plus benefits from the job offer, plus the return on the stock.

D. The following categories would be set into an input box: Investment amount, risk free rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates, all of the cash flows from the restaurant (revenues and variable and fixed costs). Once these are in the input box, formulas for calculating the incremental cash flows over time need to be set up, and the real cash flows would need to be inflated and then discounted. If depreciation is relevant for the investment, a MACRS table would need to be added.

E. Uncertainties about a new job include lack of information about the people Jackson would work with, and also about the nature of the work to be done. The future of the company is not guaranteed. Students may have thought of other uncertainties.

F. Jackson faces uncertainties about customer preferences, which will result in uncertainty about revenues. He has not operated a restaurant, so he faces uncertainties about current costs and cost trends over time. He also faces uncertainties about the quality and quantity of employees available to cook, wait tables, and perform other tasks that need to be done.

G. Jackson faces many uncertainties, no matter which alternative he chooses. If he performs sensitivity analyses around each alternative and formally incorporates qualitative factors, such as the amount of enjoyment he takes in his current position and his perceptions of this aspect of owning a restaurant, he will be able to make a high quality decision.


12.25 Homeless Shelter

[Notes about problem complexity: Part A is not coded as Step 2 because the advantages and disadvantages are explicitly presented in the text. Part C will be quite difficult for most students.]

A. Advantages of IRR It is easy to explain It can be calculated using a spreadsheet

Disadvantages Without spreadsheets, it is time consuming to calculate It does not take into consideration the relative size of projects It does not give information about the dollar value of the

investment.

B. The discount rate should be different for every project because the risk of every project is different. Part of the discount rate is the risk premium, and that should be higher for projects that are riskier.

C. For discount rates, the following information would be helpful: current and historical inflation rates and T-bill rates. In addition, historical financial information about the three alternative projects or similar projects in similar would be important to develop the risk premium. Information about demand for rooms, apartments, and boxes would be needed. Information about the availability of management and employees for the three alternatives would be useful.

D. The answer to this question depends in part upon the assumptions made about the current operations of the homeless shelter. If the shelter’s current operations are similar to an apartment complex, the second alternative is probably least risky because of the rent subsidization, the first alternative next most risky, and the manufacturing operation most risky. Information about demand and employee stability is likely to be more uncertain than information about occupancy rates, etc. However, if the homeless shelter is just a large space with cots for homeless people, the managers’ experience may be irrelevant when considering risk.

The amount of financial risk also depends on the size of investment. The managers need to consider potential problems that could affect financial outcomes. A hotel that offers rooms based on ability to pay could attract people who are using the hotel for illegal activities and require a great deal of monitoring. Alternatively, the manufacturing operation requires managers who are trained to work with homeless people and skilled at managing manufacturing operations. To better understand the financial risks for the three different types of operations, the managers may want to find similar businesses in the local area and examine their revenues and expenses across time. Managers of not-for-profit organizations are often willing to share information with each other.


12.26 Real Interest Rates

A. The real rate includes both a risk free rate and a risk premium.

B. The risk free rate is affected by decisions by the Federal Reserve about the prime rate, and economic growth rates. The level of uncertainty and potential volatility of the cash flows for the project affect the risk premium.

C. Interest rates vary a great deal across time. They are affected by government policy, inflation, stock market returns, and many other factors that are difficult to predict.

D. Yes, the length of the project can make a difference in the certainty of the chosen rate. Interest and inflation rates usually trend across time; they move slowly up or down. If the project has a short life (3-5 years) and rates are currently low (or high), managers would expect them to rise ( or decrease), but slowly. The choice of discount rate is less certain for projects with long lives (15-20 years or more). Interest and inflation rates could vary a great deal over this length of time, and predicting the average rate for the entire time period involves more uncertainty.

12.27 Green Jade Resorts

A.Net Present Value (NPV): The sum of today’s and future cash flows discounted to today’s dollars

Internal Rate of Return (IRR): Discount rate necessary for the present value of the discounted cash flows to be equal to the investment

Payback Method: Measures the amount of time required to recover the initial investment

Accrual Accounting Rate of Return: Expected increase in average annual operating income as a percent of the initial increase in required investment

B.Net Present Value (NPV)

Pros Incorporates the time value of money Calculates the discounted cash flows discounted in today’s dollars If multiple projects are being considered, it is easier to identify the most

profitable projectsCons

Requires estimating cash flows and choosing an appropriate discount rate


Internal Rate of Return (IRR)Pros

Intuitively easier to understand for many managers Can be used to compare potential projects to other ones

Cons Computationally more difficult, particularly with uneven cash flows Cannot sum or average IRR for multiple projects Assumes cash flows can be reinvested at the IRR

Payback MethodPros

Focuses on high risk of long payback period Used extensively, particularly outside of the U.S.

Cons Does not incorporate time value of money Ignores cash flows received after the investment is recovered

Accrual Accounting Rate of ReturnPros

Use for division or department performance because data is readily available

Cons Does not incorporate time value of money Cost of investment is double-counted Not appropriate for capital budget decisions

C. Price changes and consumer preferences cannot be easily predicted across time. This type of business is greatly affected by changes in economic conditions. When the economy is strong, people have more money for vacation travel, but it is a discretionary cost that is cut during economic downturns. In addition, consumer preferences change over time, and are affected by competing resort availability. These factors decrease the accuracy of any predictions made.

D. The NPV method and NPV profitability index would be the best quantitative methods for this decision. Using these methods inflation rates can be altered to more accurately reflect differences in inflation rates in the three different locations. Further, it is difficult to compare rates of return under the IRR method and the payback and accounting rate of return methods do not incorporate the time value of money.

E. The managers may respond unfavorably to methods with which they are unfamiliar. Therefore, it is important to make an educational presentation that simply explains the recommended method and that emphasizes its benefits.

F. There are many different types of memos that can be written. At a minimum, the memo should briefly describe the pros and cons of their current method (payback) and of a preferred alternative. The memo should be written in non-technical language that


managers can easily understand, and it should also address the managers’ concerns about changing methods.

12.28 Irrigation Supply

A.Cash Flow Timeline:

Time 0 Years1-5 Year 5Investment $(20,000)Incremental cash flows:

Operating income $6,000 (a)Taxes (500) (b)

Net cash flow $5,500Terminal value $0

(a) $18,000 - $12,000(b) Taxes = net savings less depreciation times tax rate = [$6,000 –

($20,000/5)]*25%

B. NPV calculation:NPV = -$20,000 + $5,500 x (PVFA 16%, 5 years)NPV = -$20,000 + $5,500 x 3.274NPV = -$1,993

C. Payback = $20,000/$5,500 = 3.64 years

D. The results of the NPV analysis indicate that, after 5 years, Irrigation Supply will have lost $1,993 in today’s dollars. This means that the investment will not have paid for itself in 5 years. Results from the payback method indicate that the investment will be recovered in 3.33 years. The payback period is shorter than 5 years because the time value of money and income taxes are not taken into consideration.

E. A number of different factors affect prices and demand. If competitors’ prices decrease, the hardware store may not be able to pay the current price. New technology could make the sprinkler heads obsolete. Weather patterns could change and alter demand. Land use could change, altering demand. These are just a few examples, students may think of others.

F. If Irrigation Supply relies on the hardware store for a portion of the contribution margin, any changes experienced by the hardware store will have an affect on Irrigation Supply. If the portion is small, the effect will be small, and if it is large, the effect could be quite large.


12.29 Carbondale Architectural Design Group

A. Data for this problem is summarized as follows:Investment $110,000Annual Annuity $36,000Period 5 yearsDiscount rate 18%Terminal value $0Annual depreciation $22,000Tax rate 25%Taxes $3,500After Tax CF $32,500

NPV calculation:PV of CF ($32,500 x 3.127 - PVFA 5 yrs, 18%) $ 101,626Investment $(110,000 )

NPV $ (8,374)

B.

C. When the cash flows are inflated, the discount rate and cash flows are valued consistently in nominal terms. Therefore incorporating inflation increases the accuracy of the analysis. Using a nominal discount rate with real cash flows underestimated the cash flows and understated the net present value.

Inflation rate 5%Nominal rate 18.0%Income tax rate 25%Initial investment 110,000$ Terminal cash flow -$ Incremental operating cash flow 36,000$

Period 1 2 3 4 5Incremental Operating Cash Flows $36,000 $36,000 $36,000 $36,000 $36,000

Inflated $37,800 $39,690 $41,675 $43,758 $45,946Less taxes -$9,450 -$9,923 -$10,419 -$10,940 -$11,487

Terminal Cash Flow (inflated) Income Taxes on Gain

Total Relevant Cash Flow 28,350$ 29,768$ 31,256$ 32,819$ 34,460$

Calculation of depreciation tax shield MACRS Rate (5-year) 20.00% 32.00% 19.20% 11.52% 11.52% Depreciation Deduction (nominal) 22,000$ 35,200$ 21,120$ 12,672$ 12,672$ Tax savings $5,500 $8,800 $5,280 $3,168 $3,168

Present value of annual cash flowsIncremental cash flows 28,350$ 29,768$ 31,256$ 32,819$ 34,460$ Tax savings from depreciation $5,500 $8,800 $5,280 $3,168 $3,168Total 33,850$ 38,568$ 36,536$ 35,987$ 37,628$

Present value $28,686 $27,699 $22,237 $18,562 $16,447

Sum of annual cash flows 113,631$ Less initial investment 110,000$ Net present value 3,631$


D. Inflation rates change over time. Although they have been quite low over a number of years, if gasoline or labor costs inflate, general inflation will increase. If cash flows from developing countries are being valued, inflation rates could be quite high and quite volatile, and become difficult to predict.

E. If managers are using a nominal discount rate and real cash flows, they will consistently reject projects that could have a positive NPV under the nominal method.

12.30 Quik Computers


A. The problem does not specify whether the nominal or real method should be used. Because only a single inflation rate applies to all cash flows, the NPV is identical under both methods. Below are excerpts from the sample spreadsheet for each method.

Nominal Method:


Real method:

B. Any assumptions are uncertain. These include all of the variables in the analysis. They are all uncertain because they are all affected by changes in the economy, changes in consumer patterns, and changes in technology, among others.

C. Technology changes could reduce the effectiveness of the diagnostic equipment over time. If there are rapid and unexpected changes in technology, the equipment could become obsolete relatively quickly. People will have older computers that need work, but the service division may not be able to use the equipment on newer machines, and have to buy new equipment sooner than expected. This would lead to decreases in revenues prior to purchase of new equipment and increases in costs over time when newer equipment is purchased.

D. All of the variables in the input section can be varied. Students should use their judgment to determine the factors that are most likely to change rapidly, and the amounts by which they will change.

E. The answer will vary depending on the factors and range of values used. The purpose of this question is to encourage students to learn more about NPV and sensitivity analysis by exploring how fluctuations in different factors affect NPV results. Students may have difficulty deciding (1) which factors are likely to have a significant effect, and (2) how


much to modify each factor in their sensitivity analyses. Students should use reasonable judgment in making these decisions and explain their reasoning.

F. Student answers to this question will vary. However, here are some examples of pros and cons.

Pros The diagnostic system may improve service quality, increasing

customer satisfaction. It may reduce the amount of time that machines are in the shop.

Cons Kelly does not know for certain whether the diagnostic machine will

reduce costs as much as anticipated. The equipment could break down more often than expected. Employees may need special training and, if employee turnover is

high, this could be a problem.

G. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg).

12.31 The Hotshots

A. Following is the time line incorporating the algebraic approach to the solution. Notice that S is used for salary because the problem gives no information about its value. Nor does the problem provide information about the tax consequences of buying the house. Following are two solutions using two different assumptions. The first solution assumes no tax consequences for the $5 million house. The second solution assumes that the house could be amortized as a business expense over 4 years (the length of the contract).

Solution #1: Cash Flow TimelineTime 0 Years1-4

Investment $(13,000,000)Incremental cash flows:

Incremental revenues $6,000,000 (a)Incremental salary (S)Incremental taxes $(800,000) + 0.20S (b)

Net cash flow $5,200,000 – 0.80S

(a) Incremental revenues = $2 million + $2.5 million + $0.5 million + $1 million = $6 million

(b) Amortization = $2,000,000 per yearIncremental Taxes = ($6,000,000 – $2,000,000 – S) x 20%

= $(800,000) + 0.20S


Solution #2: Cash Flow TimelineTime 0 Years1-4

Investment $(13,000,000)Incremental cash flows:

Incremental revenues $6,000,000 (a)Incremental salary (S)Incremental taxes $(550,000) + 0.20S (b)

Net cash flow $5,450,000 – 0.80S

(a) Incremental revenues = $2 million + $2.5 million + $0.5 million + $1 million = $6 million

(b) Amortization = $2,000,000 per year + $5,000,000/4 = $3,250,000Incremental Taxes = ($6,000,000 – $3,250,000 – S) x 20%

= $(550,000) + 0.20S

B. The maximum salary is the salary that will bring the NPV to zero. Solve this problem algebraically by setting NPV equal to zero and solving for S:

Solution #1:0 = $(13,000,000) +[ (PVFA 4 years, 12%) x ($5,200,000 – 0.8S)]0 = $(13,000,000) + [3.037 x ($5,200,000 – 0.8S)]$2,792,400 = 2.4296SS = $1,149,325

Based on these computations, Cliff could afford to pay up to $1,149,325 in salary annually.

Solution #2:0 = $(13,000,000) + [(PVFA 4 years, 12%) x ($5,450,000 – 0.8S)]0 = $(13,000,000) + [3.037 x ($5,450,000 – 0.8S)]$3,551,650 = 2.4296SS = $1,461,825

Based on these computations, Cliff could afford to pay up to $1,461,825 in salary annually.

C. Here are factors that could affect Cliff’s willingness to sign Bob; students will probably think of others:

Are there other competing sports in the area that are played at the same time, for example college team sports?

Does Bob have a dubious reputation that could lead to behavior that would turn fans against him and the team?

Will other team mates resent having a highly paid team member when their salaries may not be nearly as high?

If the team does not have a winning season, even after Bob has been signed, will attendance fall off?


D. The signing bonus and the cost of housing for Bob would be certain once the contract is signed. However, there is uncertainty about the incremental revenue cash flows. For example, Cliff cannot know whether fans will react to Bob in the way these estimates predict. It is possible that bad publicity could arise about Bob’s behavior, which could change the expected increases in revenues. Fans can be unpredictable, and this could change the revenues greatly. Bob could become injured, and fan support would decrease. It is possible that a competing sport will reduce the amount of expected revenues. There is also uncertainty about the income tax cash flows. Income tax regulations could change, altering the tax rate or the deductibility of costs.

12.32 Wildcat Welders, Inc.


A. Below is an excerpt from the sample spreadsheet showing calculations under the nominal method. The NPV for the project is $8,101,087.

B. Worker safety could easily override a negative NPV value. In addition, sometimes insurance companies will no longer insure individuals or businesses if they do not manage their risk of liability claims well. For example, homeowners insurance is cancelled for people who own certain breeds of dogs that are known to bite people after the first claim.

C.1. Students will have a number of different responses to this question. However, their

logic should include the fact that this is replacement of equipment, which tends to be less risky than offering new products or services because the company has experience with the original equipment.


2. As the risk premium increases, the discount rate also increases. As the discount rate increases, the NPV values decrease. So an increase in the discount rate decreases the NPV.

3. Because the new equipment lowers Wildcat’s risk of future cash outflows from liability suits, it decreases their risk and therefore the risk premium should be lower.

D.1. Students will have various responses, but they should consider potential changes in

labor cost that would tend to increase, and insurance, which might tend to decrease if Wildcat’s safety record improves.

2. If cash savings increase, NPV should also increase, and vice versa.

3. This can be determined from the spreadsheet by reducing the incremental operating cash flow in the input box. Through trial and error, it can be determined that NPV is nearly zero when annual cash flows are $2,553,195.

E. If current inflation is 2% and the inflation in the analysis is 5%, the inflation rate may be too high if current trends persist. However, when inflation or risk free rates are unusually low, these rates will be expected to increase over time. The choice, then, is a matter of judgment. Students will have a variety of answers, but should consider current information about inflation trends.

12.33 Ford Motor Company

A.1. Some students will have heard about the Ford Pinto, and others will not. If students

have heard about the Pinto, they most likely have negative impressions of Ford’s decisions regarding the Pinto.

2. Students may feel that Ford was callous or even negligent in its actions. These impressions can prevent students from objectively analyzing information when responding to the remaining questions.

B. The major conflict of interest in this case involves Ford’s profitability from sales of the Pinto versus the interests of individuals and others who were harmed (physically, emotionally, or financially) from the gasoline tank explosions. The managers had an ethical dilemma over whether or how much to spend in additional testing, redesign, and/or recalls of the Pinto. Most people understand that absolute automobile safety is not achievable; they are not willing to pay beyond some unknown amount of cost for vehicle safety. Thus, the managers could not perfectly anticipate the level of safety that customers required or their willingness to pay a higher price. At the same time, however, the public expected some level of safety assurance from the Pinto. The managers needed to weigh the interests of the company and its shareholders against the interests of consumers, passengers, and others.


Another ethical issue in this case relates to governmental regulators. Regulators were responsible for setting and monitoring minimum safety standards, but they were also responsible for ensuring that standards did not become too burdensome for the automobile companies. In addition, the regulators had an ethical responsibility to treat automobile companies fairly, such as holding all companies to the same standard. The regulators faced ethical conflicts among these responsibilities in deciding how to respond to the Pinto case and also in setting new regulations.

Other automobile manufacturers also faced an ethical dilemma related to this case. When new federal regulations were established, these companies needed to consider whether they should evaluate older models for possible redesign or recall. In making their decisions, these companies were faced with ethical issues similar to those of Ford. However, their managers were under less public pressure because only the Pinto had been publicized as having problems. Nevertheless, all of the automobile companies sold cars with varying degrees of safety problems.

Jury members in the Pinto trials also faced an ethical dilemma. They needed to weigh the harm done and the reasonableness of consumer expectations against Ford’s actions, taking into account governmental regulations.

C. Numerous costs were probably ignored in the cost-benefit analysis. Managers overlooked the high reputation costs of their behavior. Their loss of reputation hurt not only sales of the Pinto, but it probably also reduced sales of other Ford products. The loss of reputation also contributed to increased competition from Japanese auto makers, who were seen as more concerned about high quality. In addition, Ford incurred high costs to redesign and recall the Pinto, and it most likely spent considerable sums to overcome negative publicity.

D. Below are discussions of the pros and cons for the two measures from the perspective of various stakeholders.

Measure used by Ford: Expected future cost of settling lawsuits filed on behalf of burn victims.

Pros: This type of measure was traditionally used by companies to evaluate costs; it was consistent with commonly-used expected future cash flow analysis for business decisions. In addition, this type of measure had previously been used by regulators. Thus, Ford’s managers probably assumed that this was an appropriate measure to use. Other U.S. automobile companies probably used a similar measure in their own cost-benefit analyses.

Cons: As discussed in Part C, this measure did not take into account numerous opportunity costs. Thus, it was not a very complete measure of expected future cash flows. Ford’s shareholders and employees would have preferred a more complete measure, which might have led Ford’s managers to different decisions in this case. The public, which included crash victims as well as potential and existing owners of Ford and other vehicles, were outraged at the idea that lawsuit costs were used by Ford in a cost-benefit analysis. They believed that this measure demonstrated callousness and unethical behavior. Ford’s managers, shareholders, employees, and


others would have preferred a different measure if they could have foreseen this reaction. Faced with public scrutiny, the regulators decided not to use this measure in their analysis of the Pinto problem.

Measure used by NHTSA: Societal value of human life.Pros: This measure allowed consideration not only of immediate economic costs, but also of indirect costs including lost incomes. Thus, it was a more complete measure of the cost of Pinto safety problems. This measure was most likely considered reasonable by the general public, victims, families, current and prospective Pinto owners, and customers of other Ford brands. These stakeholders would have been pleased at holding Ford to a greater level of social responsibility, which they probably wanted extended to other companies and industries. Ford’s employees also might have viewed this measure as more appropriate, even though it might have contributed to declining sales and loss of jobs at Ford. Obviously, the regulators decided to use this measure in their analysis; they probably believed that it would demonstrate their concern for the public interest. This measure combined with regulatory changes might also have improved long-term consumer confidence in U.S. automobiles, which would have provided long-term benefit to the companies, shareholders, employees, and U.S. economy. It also led to higher safety standards, reducing future personal and social losses.

Cons: This measure constituted a major deviation from prior practice and held Ford to a higher standard than other automobile companies. Ford’s shareholders and managers probably believed that the measure held them to an unfair and inappropriate standard. Adoption of this measure by regulators might have contributed to a decline in automobile sales at Ford and other U.S. automobile manufacturers. It might also have contributed to even more litigation against companies throughout the U.S. economy, leading to higher costs, decreased profits, and loss of jobs.

The preceding discussions did not address the preferences of Japanese automobile companies. It is not clear whether these companies used cost-benefit analyses similar to those used by U.S. automobile manufacturers. However, after World War II, Japanese manufacturers were actively involved in continuous improvement efforts aimed at higher product quality and by the 1970s had achieved a reputation for high quality. If Japanese automobile manufacturers’ definitions of higher quality also included greater vehicle safety, then they might not have used either of the measures discussed above. Instead, these manufacturers would have sought ways to eliminate safety problems regardless of how the cost was measured.

E. Ford’s managers were probably concerned primarily with meeting government requirements and maintaining their profit margins. During the late 1970s, manufacturers were not as concerned about quality or consumer responses to their decisions. Competition had been limited to a relatively small group of manufacturers, many of whom held similar values. The managers may have believed that their response was appropriate at the time. However, public outcries might have led them to give greater future consideration to the viewpoints of others.


F. In reaching conclusions about the Pinto, NHTSA staff gave more consideration to the societal value of human life than to Ford’s profitability. They might have chosen this weighting of values because of the public outcry over the Pinto problems. Prior to this episode, it appears that NHTSA staff had adopted values closer to those described in Part E for Ford’s managers. It is possible that this change was appropriate under the circumstances because it reflected a social shift toward holding companies to a higher level of responsibility. It is also possible to argue that the shift was implemented inappropriately in this circumstance because Ford was held to a standard that did not exist at the time the vehicles were manufactured, and other companies were not held to the same standard.

12.34 Favorite Fish

The spreadsheet template for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). Below is an excerpt of the contents of the spreadsheet.


A. ($22,900)

B. ($15,288)

C. ($31,323)

D. $5.79

E. $6,701

F. ($22,497)

G. ($21,596)

H. ($40,288)

I. $6.05

J. $6.16

K. $6.63

L. Current tax rates can be accessed on the Internet (e.g., www.irs.gov). For discount rates, think about alternative investments for this company at similar levels of risk. For price information, investigate prices of competitors and examine trade journals. Cost information may be more difficult to find; one would need to work in the industry to know the costs.


BUILD YOUR PROFESSIONAL COMPETENCIES

12.35 Focus on Professional Competency: Industry/Sector Perspective

A.1. Managers in relatively stable industries and sectors place greater confidence in future

cash flow estimates. In contrast, managers in less stable industries have less confidence in their cash flow estimates. For example, cash flows are highly uncertain in industries that are subject to rapid technological change or fluctuating resource costs. Even relatively stable industries become less stable with changes in the regulatory environment or new forms of competition. The certainty of long term investment decisions depends not only on the individual company, but also on the industry/sector.

2. Competitive advantages are a company’s strengths and opportunities relative to competitors. Advantages can include greater product quality or closer relationships with customers, leading to higher revenues, or it can include greater production efficiency or arrangements with suppliers, leading to lower costs. Advantages can also include the ability to take advantage of favorable income tax rates. Companies having competitive advantages also face less risk, leading to a lower required discount rate for investment projects.

3. The effects of competitive disadvantages are opposite those described in Part A.2 for competitive advantages. A company’s weaknesses relative to competitors can cause it to lose a greater proportion of revenues due to competition or an economic downturn. Its costs can also be less stable, leading to a greater likelihood that they exceed expectations. For example, a weaker company may have unreliable supplier relationships. NPV is based on expected values. However, competitive disadvantages can cause results to be less favorable than expected.

4. Managers who propose a project are often biased toward project acceptance, as discussed through the Motorola Iridium case in Chapter 1. Managers have a tendency to overestimate a project’s advantages and to underestimate its disadvantages. In addition, competitive disadvantages are sometimes difficult to identify. For example, managers may be unaware of competing projects that are under development among competitors.

B. There are many ways to monitor long-term investment projects to address risks over time. Here are two ideas; students may think of others. One approach is to measure and compare the project cash flows to expectations and investigate reasons for differences. Another approach is to periodically re-evaluate the project’s strengths and weaknesses, considering changes in the competitive and economic environment.

C. GlaxoSmithKline and other large pharmaceutical companies are often criticized for failing to develop drugs needed in underdeveloped countries or to sell drugs in those countries at low prices. Partnership with an organization such as the World Health Organization (WHO) is a highly visible way to address this type of criticism. In addition,


WHO has existing supply chain relationships in underdeveloped countries that would make it easier for GlaxoSmithKline to distribute drugs in those countries.

12.36 Integrating Across the Curriculum: Finance

A. The calculation of weighted average cost of capital requires three steps. First calculate the relative proportion of capital from each source:

ProportionSource of Capital Market Value of CapitalShort-term debt $ 300,000 $300,000/$2,300,000 13.04%Bonds 900,000 $900,000/$2,300,000 39.13Leases 200,000 $200,000/$2,300,000 8.70Common stock 900,000 $900,000/$2,300,000 39 .13

Total $2,300,000 100 .00 %

Next calculate the after-tax cost for each source of capital. The after-tax cost for debt is the pretax cost multiplied by one minus the income tax rate:

Pretax After-TaxSource of Capital Cost CostShort-term debt 8% 8%*(1-25%) 6.00%Bonds 6 6%*(1-25%) 4.50Leases 7 7%*(1-25%) 5.25Common stock 10 10.00

Finally, calculate the weighted cost for each source of capital by multiplying its after-tax cost by its proportion of the total capital. The sum of the weighted cost for all sources of capital is the weighted average cost of capital:

After-Tax WeightedSource of Capital Cost Proportion CostShort-term debt 6.00% 13.04% 0.7824%Bonds 4.50 39.13 1.7609Leases 5.25 8.70 0.4567Common stock 10.00 39.13 3 .9130

Weighted average cost of capital 6 .9130 %

B. Because interest paid on various forms of debt is tax-deductible, the actual cost of debt is the interest cost less the income tax benefit. Thus, the cost of debt must be calculated as an after-tax cost.

C. Ideally, the discount rate in a capital budgeting problem should be the return on other investment opportunities of similar risk. However, it is not possible to perfectly identify the level of risk associated with a project; the project may be more or less risky than managers expect. It is also not possible to know for certain the rate of return for future projects having similar levels of risk. In addition, it is more difficult for managers to identify an appropriate discount rate for projects that are different from the ones with which they have experience.


D. The weighted average cost of capital is useful for projects that are similar in risk to the average risk of the company’s existing projects. It is a measure with which managers are familiar and understand. In addition, it may appear to be a “fair” measure across divisions and projects.However, the WACC is inappropriate if the risk level of the proposed project is higher or lower than average, leading to inappropriate rejection or acceptance.

E. Below are alternative ways to estimate the market values for each type of capital.

Short-term debt: Unless interest rates or the company’s level of risk have changed dramatically, the market value of short-term debt is fairly close to its face value.

Bonds: If the bonds are publicly traded, then the market value is readily available. If the bonds are not publicly traded, then the market value of the bonds could be estimated by discounting the future principal and interest payments using a discount rate that would be appropriate, given a current risk premium for the company’s level of risk. Alternatively, the book value could be used to estimate the market value.

Leases: The market value could be estimated by discounting future lease payments using the interest rate the company would currently incur to purchase a similar asset. Alternatively, the book value could be used to estimate the market value.

Common stock: If the company’s stock is publicly traded, then the market value is readily available. If the stock is not publicly traded, then the book value of stockholders’ equity could be used to estimate the market value. Alternatively, the market value could be estimated by discounting expected future earnings.

F. Financial statement book values often bear little relation to current market values. Financial statements do not recognize increases in the value of most assets above cost, and many intangible assets are not valued at all. Also, the values of liabilities such as bonds are not adjusted for changes in interest rates or risk. The proportion of capital from different sources might be significantly distorted by financial statement values, leading to distortion of the WACC calculation.

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