Assignment Material

Questions

1. 22-1. “Capital budgeting has the same focus as accrual accounting.” Do you agree? Explain.
2. 22-2. List and briefly describe each of the five stages in capital budgeting.
3. 22-3. What is the essence of the discounted cash flow methods?
4. 22-4. “Only quantitative outcomes are relevant in capital budgeting analyses.” Do you agree? Explain.
5. 22-5. How can sensitivity analysis be incorporated in DCF analysis?
6. 22-6. What is the payback method? What are its main strengths and weaknesses?
7. 22-7. Describe the accrual accounting rate-of-return method. What are its main strengths and weaknesses?
8. 22-8. “The trouble with discounted cash flow methods is that they ignore depreciation.” Do you agree? Explain.
9. 22-9. “Let’s be more practical. DCF is not the gospel. Managers should not become so enchanted with DCF that strategic considerations are overlooked.” Do you agree? Explain.
10. 22-10. “All overhead costs are relevant in NPV analysis.” Do you agree? Explain.
11. 22-11. Bill Watts, president of Western Publications, accepts a capital budgeting project proposed by division X. This is the division in which the president spent his first 10 years with the company. On the same day, the president rejects a capital budgeting project proposal from division Y. The manager of division Y is incensed. She believes that the division Y project has an internal rate of return at least 10 percentage points higher than the division X project. She comments, “What is the point of all our detailed DCF analysis? If Watts is panting over a project, he can arrange to have the proponents of that project massage the numbers so that it looks like a winner.” What advice would you give the manager of division Y?
12. 22-12. Distinguish different categories of cash flows to be considered in an equipment-replacement decision by a taxpaying company.
13. 22-13. Describe three ways income taxes can affect the cash inflows or outflows in a motor-vehicle-replacement decision by a taxpaying company.
14. 22-14. How can capital budgeting tools assist in evaluating a manager who is responsible for retaining customers of a cellular telephone company?
15. 22-15. Distinguish the nominal rate of return from the real rate of return.

Multiple-Choice Questions

1. 22-16. A company should accept for investment all positive NPV investment alternatives when which of the following conditions is true?
   1. a. The company has extremely limited resources for capital investment.
   2. b. The company has excess cash on its balance sheet.
   3. c. The company has virtually unlimited resources for capital investment.
   4. d. The company has limited resources for capital investment but is planning to issue new equity to ­finance additional capital investment.
2. 22-17. Which of the following items describes a weakness of the internal rate-of-return method?
   1. a. The internal rate of return is difficult to calculate and requires a financial calculator or spreadsheet tool such as Excel to calculate efficiently.
   2. b. Cash flows from the investment are assumed in the IRR analysis to be reinvested at the internal rate of return.
   3. c. The IRR calculation ignores time value of money.
   4. d. The IRR calculation ignores project cash flows occurring after the initial investment is recovered.
3. 22-18. Which of the following statements is true if the NPV of a project is $-\$\text{4,000}$ (negative $4,000) and the required rate of return is 5%?
   1. a. The project’s IRR is less than 5%.
   2. b. The required rate of return is lower than the IRR.
   3. c. The NPV assumes cash flows are reinvested at the IRR.
   4. d. The NPV would be positive if the IRR was equal to 5%.
4. 22-19. The following information pertains to the January 2, year 2 transaction replacing a print machine for Hidden Creek Enterprises, Inc.
   1. • Net book value – old print machine $20,000
   2. • Total cost of new machine $180,000
   3. • Down payment on new machine $35,000
   4. • Sale price of old machine $30,000
   5. • Tax rate 30%
5. What is the net total of relevant costs on January 2, year 2?
   1. a. $173,000
   2. b. $153,000
   3. c. $28,000
   4. d. $8,000.
6. 22-20. Nick’s Enterprises has purchased a new machine tool that will allow the company to improve the efficiency of its operations. On an annual basis, the machine will produce 20,000 units with an expected selling price of $10, prime costs of $6 per unit, and a fixed cost allocation of $3 per unit. Annual depreciation on the machine is $12,000, and the tax rate of the company is 25%.
7. What is the annual cash flow generated from the new machine?
   1. a. $63,000
   2. b. $51,000
   3. c. $18,000
   4. d. $6,000

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Exercises

1. 22-21. EXERCISES IN COMPOUND INTEREST, NO INCOME TAXES. To be sure that you understand how to use the tables in Appendix A at the end of this text, solve the following exercises. Ignore income tax considerations. The correct answers, rounded to the nearest dollar, appear at the end of this page.
   1. Required
   2. 1. You have just won $50,000. How much money will you accumulate at the end of 5 years if you invest it at 6% compounded annually? At 12%?
   3. 2. Twelve years from now, the unpaid principal of the mortgage on your house will be $249,600. How much do you need to invest today at 6% interest compounded annually to accumulate the $249,600 in 12 years?
   4. 3. If the unpaid mortgage on your house in 12 years will be $249,600, how much money do you need to invest at the end of each year at 6% to accumulate exactly this amount at the end of the 12th year?
   5. 4. You plan to save $4,800 of your earnings at the end of each year for the next 8 years. How much money will you accumulate at the end of the eighth year if you invest your savings compounded at 4% per year?
   6. 5. You have just turned 65 and an endowment insurance policy has paid you a lump sum of $400,000. If you invest the sum at 6%, how much money can you withdraw from your account in equal amounts at the end of each year so that at the end of 7 years (age 72), there will be nothing left?
   7. 6. You have estimated that for the first 6 years after you retire you will need a cash inflow of $48,000 at the end of each year. How much money do you need to invest at 4% at your retirement age to obtain this annual cash inflow? At 6%?
   8. 7. The following table shows two schedules of prospective operating cash inflows, each of which requires the same net initial investment of $18,000 now:

1. The required rate of return is 6% compounded annually. All cash inflows occur at the end of each year. In terms of net present value, which plan is more desirable? Show your computations.
2. 22-22. CAPITAL BUDGETING METHODS, NO INCOME TAXES. Heavenly Candy Company is considering purchasing a second chocolate dipping machine in order to expand its business. The information Heavenly has accumulated regarding the new machine is 

1. Heavenly estimates it will be able to produce more candy using the second machine and thus increase its annual contribution margin. It also estimates there will be a small disposal value of the machine but the cost of removal will offset that value. Ignore income tax issues in your answers. Assume all cash flows occur at year-end except for initial investment amounts.
   1. Required
   2. 1. Calculate the following for the new machine:
      1. a. Net present value
      2. b. Payback period
      3. c. Discounted payback period
      4. d. Internal rate of return (using the interpolation method)
      5. e. Accrual accounting rate of return based on the net initial investment (assume straight-line depreciation)
   3. 2. What other factors should Heavenly Candy consider in deciding whether to purchase the new machine?
2. 22-23. CAPITAL BUDGETING METHODS, NO INCOME TAXES. City Hospital, a nonprofit organization, estimates that it can save $28,000 a year in cash operating costs for the next 10 years if it buys a special-purpose eye-testing machine at a cost of $110,000. No terminal disposal value is expected. City Hospital’s required rate of return is 14%. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation.
   1. Required
   2. 1. Calculate the following for the special-purpose eye-testing machine:
      1. a. Net present value
      2. b. Payback period
      3. c. Internal rate of return
      4. d. Accrual accounting rate of return based on net initial investment
      5. e. Accrual accounting rate of return based on average investment
   3. 2. What other factors should City Hospital consider in deciding whether to purchase the special-purpose eye-testing machine?
3. 22-24. CAPITAL BUDGETING, INCOME TAXES. Assume the same facts as in Exercise 22-23 except that City Hospital is a taxpaying entity. The income tax rate is 30% for all transactions that affect income taxes.
   1. Required
   2. 1. Complete requirement 1 of Exercise 22-23 taking the income tax rate of 30% into account.
   3. 2. How would your computations in requirement 1 be affected if the special-purpose machine had a $10,000 terminal disposal value at the end of 10 years? Assume depreciation deductions are based on the $110,000 purchase cost and zero terminal disposal value using the straight-line method. Answer briefly in words without further calculations.
4. 22-25. CAPITAL BUDGETING WITH UNEVEN CASH FLOWS, NO INCOME TAXES. Eastern Cola is considering the purchase of a special-purpose bottling machine for $70,000. It is expected to have a useful life of 4 years with no terminal disposal value. The plant manager estimates the following savings in cash operating costs:

1. Eastern Cola uses a required rate of return of 20% in its capital budgeting decisions. Ignore income taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts.
2. Calculate the following for the special-purpose bottling machine:
   1. Required
   2. 1. Net present value 
   3. 2. Payback period 
   4. 3. Discounted payback period 
   5. 4. Internal rate of return (using the interpolation method) 
   6. 5. Accrual accounting rate of return based on net initial investment (Assume straight-line depreciation. Use the average annual savings in cash operating costs when computing the numerator of the accrual accounting rate of return.)

1. 22-26. COMPARISON OF PROJECTS, NO INCOME TAXES. (CMA, adapted) New Med Corporation is a rapidly growing biotech company that has a required rate of return of 12%. It plans to build a new facility in Santa Clara County. The building will take 2 years to complete. The building contractor offered New Med a choice of three payment plans, as follows:
   1. • PLAN I: Payment of $150,000 at the time of signing the contract and $4,575,000 upon completion of the building. The end of the second year is the completion date.
   2. • PLAN II: Payment of $1,775,000 at the time of signing the contract and $1,775,000 at the end of each of the two succeeding years.
   3.  • PLAN III: Payment of $450,000 at the time of signing the contract and $1,575,000 at the end of each of the three succeeding years.
      1. Required
      2. 1. Using the net present value method, calculate the comparative cost of each of the three payment plans being considered by New Med.
      3. 2. Which payment plan should New Med choose? Explain.
      4. 3. Discuss the financial factors, other than the cost of the plan, and the nonfinancial factors that should be considered in selecting an appropriate payment plan.
2. 22-27. PAYBACK AND NPV METHODS, NO INCOME TAXES. (CMA, adapted) Lulus Construction is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to $12,000,000 for the year. Lyssa Bickerson, staff analyst at Lulus, is preparing an analysis of the three projects under consideration by Caden Lulus, the company’s owner. 

1. Required

1. Because the company’s cash is limited, Lulus thinks the payback method should be used to choose between the capital budgeting projects.

a. What are the benefits and limitations of using the payback method to choose between projects?

b. Calculate the payback period for each of the three projects. Ignore income taxes. Using the payback method, which projects should Lulus choose?

2. Bickerson thinks that projects should be selected based on their NPVs. Assume all cash flows occur at the end of the year except for initial investment amounts. Calculate the NPV for each project. Ignore income taxes.

3. Which projects, if any, would you recommend funding? Briefly explain why.

1. 22-28. DCF, ACCRUAL ACCOUNTING RATE OF RETURN, WORKING CAPITAL, EVALUATION OF PERFORMANCE, NO INCOME TAXES. Green Lab plans to purchase a new centrifuge machine for its Florida facility. The machine costs $437,000 and is expected to have a useful life of 8 years, with a terminal disposal value of $42,000. Savings in cash operating costs are expected to be $85,000 per year. However, additional working capital is needed to keep the machine running efficiently. The working capital must continually be replaced, so an investment of $15,000 needs to be maintained at all times, but this investment is fully recoverable (will be “cashed in”) at the end of the useful life. Green Lab’s required rate of return is 8%. Ignore income taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts. Green Lab uses straight-line depreciation for its machines.
   1. Required
   2. 1. Calculate net present value.
   3. 2. Calculate internal rate of return.
   4. 3. Calculate accrual accounting rate of return based on net initial investment.
   5. 4. Calculate accrual accounting rate of return based on average investment.
   6. 5. You have the authority to make the purchase decision. Why might you be reluctant to base your decision on the DCF methods?
2. 22-29. NEW EQUIPMENT PURCHASE, INCOME TAXES. Jenna’s Bakery plans to purchase a new oven for its store. The oven has an estimated useful life of 4 years. The estimated pretax cash flows for the oven are as shown in the table that follows, with no anticipated change in working capital. Jenna’s Bakery has an 8% after-tax required rate of return and a 34% income tax rate. Assume depreciation is calculated on a straight-line basis for tax purposes using the initial investment in the oven and its estimated terminal disposal value. Assume all cash flows occur at year-end except for initial investment amounts.

1. Required

1. Calculate (a) net present value, (b) payback period, and (c) internal rate of return.

2. Calculate accrual accounting rate of return based on net initial investment.

1. 22-30. NEW EQUIPMENT PURCHASE, INCOME TAXES. Captain Inc. is considering the purchase of new equipment that will automate production and thus reduce labor costs. Captain made the following estimates related to the new machinery:

1. Assume depreciation is calculated on a straight-line basis for tax purposes. Assume all cash flows occur at year-end except for initial investment amounts.
   1. Required
   2. 1. Calculate (a) net present value, (b) payback period, (c) discounted payback period, and (d) internal rate of return.
   3. 2. Compare and contrast the capital budgeting methods in requirement 1.
2. 22-31. PROJECT CHOICE, TAXES. Klein Dermatology is contemplating purchasing new laser therapy equipment. This new equipment would cost $300,000 to purchase and $20,000 for installation. Klein estimates that this new equipment would yield incremental margins of $98,000 annually due to new client services but would require incremental cash maintenance costs of $10,000 annually. Klein expects the life of this equipment to be 5 years and estimates a terminal disposal value of $20,000.
3. Klein has a 25% income tax rate and depreciates assets on a straight-line basis (to terminal value) for tax purposes. The required rate of return on investments is 10%.
   1. Required
   2. 1. What is the expected increase in annual net income from investing in the new equipment?
   3. 2. Calculate the accrual accounting rate of return based on average investment.
   4. 3. Is the new equipment worth investing in from an NPV standpoint?
   5. 4. Suppose the tax authorities are willing to let Klein depreciate the new equipment down to zero over its useful life. If Klein plans to liquidate the equipment in 5 years, should it take this option? Quantify the impact of this choice on the NPV of the new equipment.
4. 22-32. CUSTOMER VALUE. Ortel Telecom sells telecommunication products and services to a variety of small businesses. Two of Ortel’s key clients are Square and Cloudburst, both fast-growing technology start-ups located in New York City. Ortel has compiled information regarding its transactions with Square and Cloudburst for 2020, as well as its expected transactions with them over the next 3 years:

1. Ortel’s transactions with Square and Cloudburst are in cash. Assume that they occur at year-end. Ortel is headquartered in the Cayman Islands and pays no income taxes. The owners of Ortel insist on a required rate of return of 12%.
   1. Required
   2. 1. What is the expected net cash flow from Square and Cloudburst for the next 3 years?
   3. 2. Based on the net present value from cash flows over the next 3 years, is Cloudburst or Square a more valuable customer for Ortel?
   4. 3. Cloudburst threatens to switch to another supplier unless Ortel gives a 10% price reduction on all sales starting in 2021. Calculate the 3-year NPV of Cloudburst after incorporating the 10% discount. Should Ortel continue to transact with Cloudburst? What other factors should Ortel consider before making its final decision?
2. 22-33. SELLING A PLANT, INCOME TAXES. (CMA, adapted) The Platinum Company is a national mattress manufacturer. Its Marion plant will become idle on December 31, 2020. Nina Simon, the corporate controller, has been asked to look at three options regarding the plant:
   1. • OPTION 1: The plant can be leased to the Coil Corporation, one of Platinum’s suppliers, for 3 years. Under the lease terms, Coil would pay Platinum $220,000 rent per year (payable at year-end) and would grant Platinum a $64,000 annual discount from the normal price of coils purchased by Platinum. (Assume that the discount is received at year-end for each of the 3 years.) Coil would bear all of the plant’s ownership costs. Platinum expects to sell this plant for $320,000 at the end of the 3-year lease.
   2. • OPTION 2: The plant could be used for 3 years to make mattress covers as an accessory to be sold with a mattress. Fixed overhead costs (a cash outflow) before any equipment upgrades are estimated to be $18,000 annually for the 3-year period (assume the fixed costs occur at year-end). The covers are expected to sell for $25 each and variable cost per unit is expected to be $10. The following production and sales of the mattress covers are expected: 2021, 22,000 units; 2022, 18,000 units; 2023, 20,000 units. In order to manufacture the mattress covers, some of the plant equipment would need to be upgraded at an immediate cost of $120,000. The equipment would be depreciated using the straight-line depreciation method and zero terminal disposal value over the 3 years it would be in use. Because of the equipment upgrades, Platinum could sell the plant for $360,000 at the end of 3 years. No change in working capital would be required.
   3. • OPTION 3: The plant, which has been fully depreciated for tax purposes, can be sold immediately for $800,000.

1. Platinum Company uses an after-tax required rate of return of 10%. Platinum is subject to a 25% tax rate on all income, including capital gains.
   1. Required
   2. 1. Calculate net present value of each of the options and determine which option Platinum should select using the NPV criterion.
   3. 2. What nonfinancial factors should Platinum consider before making its choice?

Problems

1. 22-34. EQUIPMENT REPLACEMENT, NO INCOME TAXES. Dublin Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2021, Dublin Chips expects to deliver 615 prototype chips at an average price of $95,000. Dublin Chips’ marketing vice president forecasts growth of 65 prototype chips per year through 2027. That is, demand will be 615 in 2021, 680 in 2022, 745 in 2023, and so on.
2. The plant cannot produce more than 585 prototype chips annually. To meet future demand, Dublin Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $4,200,000 if the plant is replaced. If the plant is modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the modernized plant. The old equipment is retained as part of the “modernize” alternative. The following data on the two options are available:

1. Dublin Chips uses straight-line depreciation, assuming zero terminal disposal value. For simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2021, and all transactions thereafter occur on the last day of the year. Dublin Chips’ required rate of return is 14%.
2. There is no difference between the “modernize” and “replace” alternatives in terms of required working capital. Dublin Chips has a special waiver on income taxes until 2027.
   1. Required
   2. 1. Sketch the cash inflows and outflows of the “modernize” and “replace” alternatives over the 2021–2027 period.
   3. 2. Calculate the payback period for the “modernize” and “replace” alternatives.
   4. 3. Calculate the net present value of the “modernize” and “replace” alternatives.
   5. 4. What factors should Dublin Chips consider in choosing between the alternatives?
3. 22-35. EQUIPMENT REPLACEMENT, INCOME TAXES (CONTINUATION OF 22-34). Assume the same facts as in Problem 22-34, except that the plant is located in Buffalo, New York. Dublin Chips has no special waiver on income taxes. It pays a 35% tax rate on all income. Proceeds from sales of equipment above book value are taxed at the same 35% rate.
   1. Required
   2. 1. Sketch the after-tax cash inflows and outflows of the “modernize” and “replace” alternatives over the 2021–2027 period.
   3. 2. Calculate the net present value of the “modernize” and “replace” alternatives.
   4. 3. Suppose Dublin Chips is planning to build several more plants. It wants to have the most advantageous tax position possible. Dublin Chips has been approached by Spain, Malaysia, and Australia to construct plants in their countries. Use the data in Problem 22-34 and this problem to briefly describe in qualitative terms the income tax features that would be advantageous to Dublin Chips.
4. 22-36. NPV, IRR, AND SENSITIVITY ANALYSIS. Jeong Natural Snacks is contemplating an expansion. The finance manager is looking at buying a second machine that would cost $62,000 and last for 10 years, with no disposal value at the end of that time. Jeong expects the increase in cash revenues from the expansion at $28,000 per year, with additional annual cash costs of $18,000. Jeong’s cost of capital is 8%, and the company pays no taxes because of its location in a special economic zone.
   1. Required
   2. 1. Calculate the net present value and internal rate of return for this investment.
   3. 2. Assume the finance manager of Jeong is unsure about the cash revenues and costs. The revenues could be anywhere from 10% higher to 10% lower than predicted. Assume cash costs are still $18,000 per year. What are NPV and IRR at the high and low points for revenue?
   4. 3. The finance manager thinks that costs will vary with revenues, and if the revenues are 10% higher, the costs will be 7% higher. If the revenues are 10% lower, the costs will be 10% lower. Recalculate the NPV and IRR at the high and low revenue points with this new cost information.
   5. 4. The finance manager has decided that the company should earn 2% more than the cost of capital on any project. Recalculate the original NPV in requirement 1 using the new discount rate and evaluate the investment opportunity.
   6. 5. Discuss how the changes in assumptions have affected the decision to expand.
5. 22-37. NPV AND AARR, GOAL-CONGRUENCE ISSUES. Paulina Jones, a manager for the Carpenter Manufacturing Company, has the opportunity to upgrade the equipment in the Midwest division by replacing and upgrading some of its machinery. The cost of the upgraded machinery will be $840,000 and will be depreciated using the straight-line method. The machinery is expected to have a useful life of 12 years and no residual value at the end the 12 years. The firm requires a minimum after-tax rate of return of 10% on investments. Paulina estimates annual net cash operating savings for this equipment of $150,000 before taxes and an investment in working capital at the beginning of the project of $10,000 that will be returned at the project’s end. Carpenter’s tax rate is 25%.
   1. Required
   2. 1. Calculate the net present value of this equipment.
   3. 2. Calculate the accrual accounting rate of return based on net initial investment for this equipment.
   4. 3. Should Paulina accept the project? Will Paulina accept the project if her bonus depends on achieving an accrual accounting rate of return of 10%? How can this conflict be resolved?

1. 22-38. PAYBACK METHODS, EVEN AND UNEVEN CASH FLOWS. Bobwhite Laundromat is trying to enhance the services it provides to customers, mostly college students. It is looking into the purchase of new high-efficiency washing machines that will allow for the laundry’s status to be checked via smartphone.
   1. Bobwhite estimates the cost of the new equipment at $178,000. The equipment has a useful life of 9 years. Bobwhite expects cash fixed costs of $87,000 per year to operate the new machines, as well as cash variable costs in the amount of 10% of revenues. Bobwhite evaluates investments using a cost of capital of 6%.
   2. Required
   3. 1. Calculate the payback period and the discounted payback period for this investment, assuming Bobwhite expects to generate $190,000 in incremental revenues every year from the new machines.
   4. 2. Assume instead that Bobwhite expects the following uneven stream of incremental cash revenues from installing the new washing machines:

1. Based on this estimated revenue stream, what are the payback and discounted payback periods for the investment?
2. 22-39. REPLACEMENT OF A MACHINE, INCOME TAXES, SENSITIVITY. (CMA, adapted) The Kuhl Brothers own a frozen custard ice cream shop. The brothers currently are using a machine that has been in use for the last 4 years. On January 1, 2020, the Kuhl Brothers are considering buying a new machine to make their frozen custard. The Kuhl Brothers have two options: (1) continue using the old freezing machine or (2) sell the old machine and purchase a new freezing machine. The seller of the new machine is not interested in a trade-in of Kuhl’s old machine. The following information has been obtained:

1. The Kuhl Brothers are subject to a 25% income tax rate. Any gain or loss on the sale of machines is treated as an ordinary tax item and will affect the taxes paid by the Kuhl Brothers in the year in which it occurs. The Kuhl Brothers have an after-tax required rate of return of 8%. Assume all cash flows occur at year-end except for initial investment amounts.
   1. Required
   2. 1. The Kuhl Brothers ask you whether they should buy the new machine. To help in your analysis, calculate the following:
      1. a. One-time after-tax cash effect of disposing of the old machine on January 1, 2020
      2. b. Annual recurring after-tax cash operating savings from using the new machine (variable and fixed)
      3. c. Cash tax savings due to differences in annual depreciation of the old machine and the new machine
      4. d. Difference in after-tax cash flow from terminal disposal of new machine and old machine
   3. 2. Use your calculations in requirement 1 and the net present value method to determine whether the Kuhl Brothers should continue to use the old machine or acquire the new machine.
   4. 3. How much more or less would the recurring after-tax cash operating savings of the new machine need to be for the Kuhl Brothers to earn exactly the 8% after-tax required rate of return? Assume that all other data about the investment do not change.
2. 22-40. RECOGNIZING CASH FLOWS FOR CAPITAL INVESTMENT PROJECTS. Johnny Buster owns Entertainment World, a place that combines fast food, innovative beverages, and arcade games. Worried about the shifting tastes of younger audiences, Johnny contemplates bringing in new simulators and virtual reality games to maintain customer interest.
3. As part of this overhaul, Johnny is also looking at replacing his old Guitar Hero equipment with a Rock Band Pro machine. The Guitar Hero setup was purchased for $25,200 and has accumulated depreciation of $23,000, with a current trade-in value of $2,700. It currently costs Johnny $600 per month in utilities and another $5,000 a year in maintenance to run the Guitar Hero equipment. Johnny estimates that the equipment could be kept in service for another 11 years, after which it would have no salvage value.
4. The Rock Band Pro machine is more energy efficient and durable. It would reduce the utilities costs by 30% and cut the maintenance cost in half. The Rock Band Pro costs $49,000 and has an expected disposal value of $5,000 at the end of its useful life of 11 years.
5. Johnny charges an entrance fee of $5 per hour for customers to play an unlimited number of games. He does not believe that replacing Guitar Hero with Rock Band Pro will have an impact on this charge or materially change the number of customers who will visit Entertainment World.
   1. Required
   2. 1. Johnny decides to evaluate the Rock Band Pro purchase using capital budgeting techniques. To help him, read through the problem and separate the cash flows into four groups: (1) net initial investment cash flows, (2) cash flow savings from operations, (3) cash flows from terminal disposal of investment, and (4) cash flows not relevant to the capital budgeting problem.
   3. 2. Assuming a tax rate of 40%, a required rate of return of 8%, and straight-line depreciation over the remaining useful life of equipment, should Johnny purchase Rock Band Pro?
6. 22-41. NPV, INFLATION AND TAXES. TriMart is considering replacing 20 of their checkout registers with new self-checkout equipment. The equipment currently being used is fully depreciated and has no disposal value. The new equipment will cost a total of $220,000. Because the new equipment is self-serve, TriMart will have annual incremental cash savings in labor costs of $60,000 per year. The equipment will have a 5-year useful life and no terminal disposal value. The equipment will be depreciated using the straight-line method. TriMart requires a 4% real rate of return.
   1. Required
   2. 1. Given the preceding information, what is the net present value (NPV) of the new equipment? Ignore taxes.
   3. 2. Assume the $60,000 cost savings are in current real dollars and the inflation rate is 2%. Recalculate the NPV of the project.
   4. 3. Based on your answers to requirements 1 and 2, should TriMart buy the new checkout equipment?
   5. 4. Now assume that the company’s tax rate is 20%. Calculate the NPV of the equipment assuming no inflation.
   6. 5. Again assuming that the company faces a 20% tax rate, calculate the NPV of the equipment under an inflation rate of 2%.
   7. 6. Based on your answers to requirements 4 and 5, should TriMart buy the new checkout equipment?
7. 22-42. RECOGNIZING CASH FLOWS FOR CAPITAL INVESTMENT PROJECTS, NPV. Shalie Manufacturing makes several thousand different metal products, including building materials, tools, and furniture parts. The manager of the furniture parts division has proposed that his division expand into bicycle parts. The furniture parts division currently generates cash revenues of $5,000,000 and incurs cash costs of $3,550,000, with an investment in assets of $12,050,000. One-fourth of the cash costs are direct labor.
8. The manager estimates that the expansion of the business will require an investment in working capital of $25,000. Because the company already has a facility, there would be no additional rent or purchase costs for a building, but the project would require an additional $390,000 in annual cash overhead. Moreover, the manager expects annual materials cash costs for bicycle parts to be $1,300,000, and labor for the bicycle parts to be about the same as the labor cash costs for furniture parts.
9. The controller of Shalie, working with various managers, estimates that the expansion would require the purchase of equipment with a $2,575,000 cost and an expected disposal value of $370,000 at the end of its 7-year useful life. Depreciation would occur on a straight-line basis.
10. The CFO of Shalie determines the firm’s cost of capital as 14%. The CFO’s salary is $150,000 per year. Adding another division will not change that. The chief executive officer asks for a report on expected revenues for the project, and is told by the marketing department that it might be able to achieve cash revenues of $3,372,500 annually from bicycle parts. Shalie Manufacturing has a tax rate of 35%.
    1. Required
    2. 1. Separate the cash flows into four groups: (a) net initial investment cash flows, (b) cash flows from operations, (c) cash flows from terminal disposal of investment, and (d) cash flows not relevant to the capital budgeting problem.
    3. 2. Calculate the NPV of the expansion project and comment on your analysis.

Answers to Exercises in Compound Interest (Exercise 22-21)

The general approach to these exercises centers on a key question: Which of the four basic tables in Appendix A should be used? No computations should be made until this basic question has been answered with confidence.

1. FROM TABLE 1. The $50,000 is the present value P of your winnings. Their future value S in 5 years will be as follows:

1. The conversion factor, $(1+r{)}^n$, is on line 5 of Table 1.

2. FROM TABLE 2. The $249,600 is a future value. You want the present value of that amount, $P=S÷(1+r{)}^n$. The conversion factor, $1÷(1+r{)}^n$, is on line 12 of Table 2. Substituting,

3. FROM TABLE 3. The $249,600 is a future value. You are seeking the uniform amount (annuity) to set aside annually. Note that $1 invested each year for 12 years at 6% has a future value of $16.870 after 12 years, from line 12 of Table 3.

4. FROM TABLE 3. You need to find the future value of an annuity of $4,800 per year. Note that $1 invested each year for 8 years at 4% has a future value of $9.214 after 8 years.

5. FROM TABLE 4. When you reach age 65, you will get $400,000, the present value at that time. You need to find the annuity that will exactly exhaust the $400,000 in 7 years. To pay yourself $1 each year for 7 years when the interest rate is 6% requires you to have $5.582 today, from line 7 of Table 4.

6. FROM TABLE 4. You need to find the present value of an annuity for 6 years at 4% and at 6%:

7. FROM TABLE 2. Plans A and B both have positive net present values because the present value of their cash inflows exceeds their outflow of $18,000. If only one plan can be chosen, Plan B is preferable because the NPV of plan B exceeds that of plan A by $857.

1. Even though plans A and B have the same initial outflow and the same total cash inflows over the 5 years, plan B is preferred because it has greater cash inflows occurring earlier.