Short-Answer Questions

• How do capital expenditures differ from ordinary expenditures?
• What effects can capital-budgeting decisions have on a company?
• What effect does depreciation have on cash flow?
• Give an example of an out-of-pocket cost and a sunk cost by describing a situation in which both are encountered.
• A machine is being considered for purchase. The salesperson attempting to sell the machine says that it will pay for itself in five years. What is meant by this statement?
• Discuss the limitations of the payback period method.
• What is the profitability index, and of what value is it?
• What is the time-adjusted rate of return on a capital investment?
• What role does the cost of capital play in the time-adjusted rate of return method and in the net present value method?
• What is the purpose of a postaudit? When should a postaudit be performed?
• A friend who knows nothing about the concepts in this chapter is considering purchasing a house for rental to students. In just a few words, what would you tell your friend to think about in making this decision?

Exercises

Exercise A Diane Manufacturing Company is considering investing $600,000 in new equipment with an estimated useful life of 10 years and no salvage value. The equipment is expected to produce $240,000 in cash inflows and $160,000 in cash outflows annually. The company uses straight-line depreciation, and has a 40% tax rate. Determine the annual estimated net income and net cash inflow.

Exercise B Zen Manufacturing Company is considering replacing a four-year-old machine with a new, advanced model. The old machine was purchased for $60,000, has an estimated useful life of 10 years with no salvage value, and has annual maintenance costs of $15,000. The new machine would cost $45,000, but annual maintenance costs would be only $6,000. The new machine would have an estimated useful life of 10 years with no salvage value. Using straight-line depreciation and an assumed 40% tax rate, compute the additional annual cash inflow if the old machine is replaced.

Exercise C Given the following annual costs, compute the payback period for the new machine if its initial cost is $420,000.

Exercise D Jefferson Company is considering investing $33,000 in a new machine. The machine is expected to last five years and to have a salvage value of $8,000. Annual before-tax net cash inflow from the machine is expected to be $7,000. Calculate the unadjusted rate of return. The income tax rate is 40%.

Exercise E Compute the profitability index for each of the following two proposals assuming the desired minimum rate of return is 20%. Based on the profitability indexes, which proposal is better?

Exercise F Ross Company is considering three alternative investment proposals. Using the following information, rank the proposals in order of desirability using the payback period method.

Exercise G Simone Company is considering the purchase of a new machine costing $50,000. It is expected to save $9,000 cash per year for 10 years, has an estimated useful life of 10 years, and no salvage value. Management will not make any investment unless at least an 18% rate of return can be earned. Using the net present value method, determine if the proposal is acceptable. Assume all tax effects are included in these numbers.

Exercise H Refer to the data in previous exercise. Calculate the time-adjusted rate of return.

Exercise I Rank the following investments for Renate Company in order of their desirability using the (a) payback period method, (b) net present value method, and (c) time-adjusted rate of return method. Management requires a minimum rate of return of 14%.

Problems

Problem A Hamlet Company is considering the purchase of a new machine that would cost $300,000 and would have an estimated useful life of 10 years with no salvage value. The new machine is expected to have annual before-tax cash inflows of $100,000 and annual before-tax cash outflows of $40,000. The company will depreciate the machine using straight-line depreciation, and the assumed tax rate is 40%.

a. Determine the net after-tax cash inflow for the new machine.

b. Determine the payback period for the new machine.

Problem B Graham Company currently uses four machines to produce 400,000 units annually. The machines were bought three years ago for $50,000 each and have an expected useful life of 10 years with no salvage value. These machines cost a total of $30,000 per year to repair and maintain.

The company is considering replacing the four machines with one technologically superior machine capable of producing 400,000 units annually by itself. The machine would cost $140,000 and have an estimated useful life of seven years with no salvage value. Annual repair and maintenance costs are estimated at $14,000.

Assuming straight-line depreciation and a 40% tax rate, determine the annual additional after-tax net cash inflow if the new machine is acquired.

Problem C Macro Company owns five machines that it uses in its manufacturing operations. Each of the machines was purchased four years ago at a cost of $120,000. Each machine has an estimated life of 10 years with no expected salvage value. A new machine has become available. One new machine has the same productive capacity as the five old machines combined; it can produce 800,000 units each year. The new machine will cost $648,000, is estimated to last six years, and will have a salvage value of $72,000. A trade-in allowance of $24,000 is available for each of the old machines. These are the operating costs per unit:

Ignore federal income taxes. Use the payback period method for (a) and (b).

a. Do you recommend replacing the old machines? Support your answer with computations. Disregard all factors except those reflected in the data just given.

b. If the old machines were already fully depreciated, would your answer be different? Why?

c. Using the net present value method with a discount rate of 20%, present a schedule showing whether or not the new machine should be acquired.

Problem D Span Fruit Company has used a particular canning machine for several years. The machine has a zero salvage value. The company is considering buying a technologically improved machine at a cost of $232,000. The new machine will save $50,000 per year after taxes in cash operating costs. If the company decides not to buy the new machine, it can use the old machine for an indefinite time by incurring heavy repair costs. The new machine would have an estimated useful life of eight years.

a. Compute the time-adjusted rate of return for the new machine.

b. Management thinks the estimated useful life of the new machine may be more or less than eight years. Compute the time-adjusted rate of return for the new machine if its useful life is (1) 5 years and (2) 12 years, instead of 8 years.

c. Suppose the new machine’s useful life is eight years, but the annual after-tax cost savings are only $45,000. Compute the time-adjusted rate of return.

d. Assume the annual after-tax cost savings from the new machine will be $35,000 and its useful life will be 10 years. Compute the time-adjusted rate of return.

Problem E Merryll, Inc., is considering three different investments involving depreciable assets with no salvage value. The following data relate to these investments:

The income tax rate is 40%. Management requires a minimum return on investment of 12%.

Rank these proposals using the following selection techniques:

a. Payback period.

b. Unadjusted rate of return.

c. Profitability index.

d. Time-adjusted rate of return.

Problem F Slow to Change Company has decided to computerize its accounting system. The company has two alternatives—it can lease a computer under a three-year contract or purchase a computer outright.

If the computer is leased, the lease payment will be $5,000 each year. The first lease payment will be due on the day the lease contract is signed. The other two payments will be due at the end of the first and second years. The lessor will provide all repairs and maintenance.

If the company purchases the computer outright, it will incur the following costs:

The computer is expected to have only a three-year useful life because of obsolescence and technological advancements. The computer will have no salvage value and be depreciated on a double-declining-balance basis. Slow to Change Company’s cost of capital is 16%.

a. Calculate the net present value of out-of-pocket costs for the lease alternative.

b. Calculate the net present value of out-of-pocket costs for the purchase alternative.

c. Do you recommend that the company purchase or lease the machine?

Problem G Van Gogh Sports Company is trying to decide whether to add tennis equipment to its existing line of football, baseball, and basketball equipment. Market research studies and cost analyses have provided the following information:

Van Gogh will need additional machinery and equipment to manufacture the tennis equipment. The machines and equipment will cost $450,000, have an estimated 10-year useful life, and have a $10,000 salvage value.

Sales of tennis equipment for the next 10 years have been projected as follows:

Variable costs are 60% of selling price, and fixed costs (including straight-line depreciation) will total $88,500 per year.

The company must advertise its new product line to gain rapid entry into the market. Its advertising campaign costs will be:

The company requires a 14% minimum rate of return on investments.

Using the net present value method, decide whether or not Van Gogh Sports Company should add the tennis equipment to its line of products. (Ignore federal income taxes.) Round to the nearest dollar.

Problem H Jordan Company is considering purchasing new equipment costing $2,400,000. Jordan estimates that the useful life of the equipment will be five years and that it will have a salvage value of $600,000. The company uses straight-line depreciation. The new equipment is expected to have a net cash inflow (before taxes) of $258,000 annually. Assume that the tax rate is 40% and that management requires a minimum return of 14%.

Using the net present value method, determine whether the equipment is an acceptable investment.

Problem I Penny Company has an opportunity to sell some equipment for $40,000. Such a sale will result in a tax-deductible loss of $4,000. If the equipment is not sold, it is expected to produce net cash inflows after taxes of $8,000 for the next 10 years. After 10 years, the equipment can be sold for its book value of $4,000. Assume a 40% federal income tax rate.

Management currently has other opportunities that will yield 18%. Using the net present value method, show whether the company should sell the equipment. Prepare a schedule to support your conclusion.

Alternate problems

Alternate problem A Mark’s Manufacturing Company is currently using three machines that it bought seven years ago to manufacture its product. Each machine produces 10,000 units annually. Each machine originally cost $25,500 and has an estimated useful life of 17 years with no salvage value.

The new assistant manager of Mark’s Manufacturing Company suggests that the company replace the three old machines with two technically superior machines for $22,500 each. Each new machine would produce 15,000 units annually and would have an estimated useful life of 10 years with no salvage value.

The new assistant manager points out that the cost of maintaining the new machines would be much lower. Each old machine costs $2,500 per year to maintain; each new machine would cost only $1,500 a year to maintain.

Compute the increase in after-tax annual net cash inflow that would result from replacing the old machines; use straight-line depreciation and an assumed tax rate of 40%.

Alternate problem B Fed Extra Company is considering replacing 10 of its delivery vans that originally cost $30,000 each; depreciation of $18,750 has already been taken on each van. The vans were originally estimated to have useful lives of eight years and no salvage value. Each van travels an average of 150,000 miles per year. The 10 new vans, if purchased, will cost $36,000 each. Each van will be driven 150,000 miles per year and will have no salvage value at the end of its three-year estimated useful life. A trade-in allowance of $3,000 is available for each of the old vans. Following is a comparison of costs of operation per mile:

Use the payback period method for (a) and (b).

a. Do you recommend replacing the old vans? Support your answer with computations and disregard all factors not related to the preceding data.

b. If the old vans were already fully depreciated, would your answer be different? Why?

c. Assume that all cost flows for operating costs fall at the end of each year and that 18% is an appropriate rate for discounting purposes. Using the net present value method, present a schedule showing whether or not the new vans should be acquired.

Alternate problem C Mesa Company has been using an old-fashioned computer for many years. The computer has no salvage value. The company is considering buying a computer system at a cost of $35,000. The new computer system will save $7,000 per year after taxes in cash (including tax effects of depreciation). If the company decides not to buy the new computer system, it can use the old one for an indefinite time. The new computer system will have an estimated useful life of 10 years.

a. Compute the time-adjusted rate of return for the new computer system.

b. The company is uncertain about the new computer system’s 10-year useful life. Compute the time-adjusted rate of return for the new computer system if its useful life is (1) 6 years and (2) 15 years, instead of 10 years.

c. Suppose the computer system has a useful life of 10 years, but the annual after-tax cost savings are only $4,500. Compute the time-adjusted rate of return.

d. Assume the annual after-tax cost savings will be $7,500 and the useful life will be eight years. Compute the time-adjusted rate of return.

Alternate problem D Ott’s Fresh Produce Company has always purchased its trucks outright and sold them after three years. The company is ready to sell its present fleet of trucks and is trying to decide whether it should continue to purchase trucks or whether it should lease trucks. If the trucks are purchased, the company will incur the following costs:

At the end of three years, the trucks could be sold for a total of $96,000. Another fleet of trucks would then be purchased. The costs just listed, including the same acquisition cost, also would be incurred with respect to the second fleet of trucks. The second fleet also could be sold for $96,000 at the end of three years.

If the company leases the trucks, the lease contract will run for six years. One fleet of trucks will be provided immediately, and a second fleet of trucks will be provided at the end of three years. The company will pay $126,000 per year under the lease contract. The first lease payment will be due on the day the lease contract is signed. The lessor bears the cost of all repairs.

Using the net present value method, determine if the company should buy or lease the trucks. Assume the company’s cost of capital is 18%. (Ignore federal income taxes.)

Beyond the numbers—Critical thinking

Business decision case A Lloyd’s Company wishes to invest $750,000 in capital projects that have a minimum expected rate of return of 14%. The company is evaluating five proposals. Acceptance of one proposal does not preclude acceptance of any of the other proposals. The company’s criterion is to select proposals that meet its 14% minimum required rate of return. The relevant information related to the five proposals is as follows:

a. Compute the net present value of each of the five proposals.

b. Which projects should be undertaken? Why? Rank them in order of desirability.

Business decision case B Slick Company is considering a capital project involving a $225,000 investment in machinery and a $45,000 investment in working capital. The machine has an expected useful life of 10 years and no salvage value. The annual cash inflows (before taxes) are estimated at $90,000 with annual cash outflows (before taxes) of $30,000. The company uses straight-line depreciation. Assume the federal income tax rate is 40%.

The company’s new accountant computed the net present value of the project using a minimum required rate of return of 16% (the company’s cost of capital). The accountant’s computations follow:

a. Are the accountant’s computations correct? If not, compute the correct net present value.

b. Is this capital project acceptable to the company? Why or why not?

An accounting perspective – Writing experience C Refer to “An accounting perspective: Business insight”. Write a brief paper explaining why managers in Japan might use lower measures of the cost of capital than US managers.

Ethics case – Writing experience D Rebecca Peters just learned that First Bank’s investment review committee rejected her pet project, a new computerized method of storing data that would enable customers to have instant access to their bank records. Peters’ software consulting firm specializes in working with financial institutions. This project for First Bank was her first as project manager.

Following up, Peters learned that First Bank’s investment review committee liked the idea but were not convinced that the new software’s financial benefits would justify the cost of the software. When she told a colleague about the rejection at First Bank, the colleague said, “Why not tell the committee this software will increase the bank’s profits? After we installed the software in the bank in Indianapolis, Indiana, USA their profits increased substantially. We even have data from that bank that you could present.”

Peters thought about the suggestion. She knew First Bank would be pleased with the software if they installed it, and she wanted to make the sale. She also knew that the situation in Indianapolis, Indiana, USA was different; profits there had increased primarily because of other software that had reduced the bank’s operating costs.

What should Rebecca Peters do? Write her a letter telling what you would do.

Group assignment E For summer employment, a friend is considering investing in a coffee stand on a busy street near office buildings. Being unfamiliar with the concepts in this chapter, your friend does not know how to make the decision. In teams of four, help your friend get started by providing a framework and questions that your friend should answer. (For example, how much will the investment be? How much are the estimated cash flows from sales?) Prepare a memorandum from the group to your instructor; list your questions and suggestions for your friend. In the heading, include the date, to whom it is written, from whom, and the subject matter.

Group project F You have the option of choosing between two projects with equal total cash flows over five years but different annual cash flows. In groups of two or three students, determine which project should be selected for investment. Write a memorandum to your instructor addressing this issue. Be sure to provide examples to reinforce your answer. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Group project G A manager comments to her superior, “There is no need to perform a postaudit. The project was justified based on our initial projections and we were given the green light to proceed. It has been a year since we started the project, a postaudit would be a waste of time.” In groups of two or three students, respond to this comment. Do you agree? Do you disagree? If this manager is right, why bother with a postaudit? Write a memorandum to your instructor addressing these questions. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Using the Internet—A view of the real world

Using any Internet search engine enter “budgeting” . Select an article that directly discusses budgeting in an organization or industry and print a copy of the article. You are encouraged (but not required) to find an article that answers some of the following questions: What is the purpose of budgeting? How are budgets developed? How is budgeting used to motivate employees? How might budgeting create ethical dilemmas?

Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.

Using any Internet search engine select one of the new terms at the end of the chapter and perform a key word search. Be sure to include quotation marks (for example: “Payback period”). Select an article that directly discusses the new term used, and print a copy of the article. Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.