M7 The Capital Budget:
Evaluating Capital Expenditures
DISCUSSION QUESTIONS
7-1.A company’s nonfinancial goals may include providing quality service to customers, recruiting and employing high qualified workers, providing a safe, pleasant environment for its employees and customers, and creating an atmosphere that respects its customers and employees. Working toward these goals will likely create an atmosphere conducive to the company having a long, profitable existence. Several financial effects, both immediate and long term will likely result. These might include:
- Expansion of the customer base to include a larger market share and more return customers
- Avoidance of fines and negative press by regulatory agencies
- Future direct revenue increases as a result of quality products and services provided by trained and competent employees
- Higher employee retention to reduce new employee training costs
Your students may list various other possible financial effects. Point out that effects may impact revenue and expenses, both in the current accounting period and in subsequent years as the ripple effect of today’s actions roll into the future.
7-2.There are various possible financial effects if a hospital does not work toward nonfinancial goals. Not working towards these goals could create several negative financial effects, both immediate and in the long term. These might include: loss of customers; assessment of fines by regulatory agencies; future revenue decreases as a result of competition attracting a company’s customers; poor quality of products and service from poorly trained or incompetent employees; and high employee turnover. Your students may list various other possible financial effects. Point out that effects may impact revenue and expenses, both in the current accounting period and in subsequent years as the ripple effect of today’s actions roll into the future.
7-3.To determine when the hospital’s nonfinancial goals are reached, management could employ consultants or internal departments to conduct surveys of patients and employees as well as having patients prepare comment cards upon discharge. This would create feedback for management to correct initiatives that many not be accomplishing the agreed-upon nonfinancial goals. Emphasize to your students that it is very difficult, if not almost impossible to determine when the goals have been attained. The hospital should employ continual efforts to improve nonfinancial goals even if status quo appears met.
7-4.In developing and releasing a major new software product, issues concerning market acceptance of new ideas require management to assess the worth of the product. The possibility that the new product could generate either limited or wide acceptance would influence Microsoft’s financial position. An operating system is a major aspect of any computer system that has a big impact on whether the computer will actually operate effectively or not. Unfortunately, one of the biggest strains on capital for software companies is the timing of when the company will be paid for its product development, which occurs for a long period of time prior to earning revenue and receiving the cash from the sales. The biggest challenge for Microsoft is probably, “Will I be paid?” and “When will I be paid?” as both present uncertainties during the product development stage.
7-5.A key decision Elizabeth must face in selling one stock investment and buying another is the uncertainty of the return on the new stock. Will Emry Company consistently provide a 17% return, or is this percentage an estimate, or a short-term projection? The risk of the investment should also be considered. How long has the company been in business? Is the company in an industry that is known for volatility. In spite of other factors, a 17% return could be a motivating factor that may offset the future volatility of Emry, and therefore, may likely be the best decision for her.
7-6.This question is likely answered differently by individual students depending on the risk each individual may tolerate. Point out to your students that high return companies during one period may be considered low return companies during a different reporting period. It is important to note that most students may chose high return companies, but those that chose medium return companies will more likely be staying with the same companies for the longest duration and experience the long-term best return (due to the lack of volatility).
7-7.Most, if not all students, would respond that switching to the other company’s stock would be preferable. The reasoning is rather straightforward: investing in the 20% return company will yield 12% more of a return every year the market values stay in this proportion. Most investors know that proving the 20% is possible only after the fact. Investors are willing to buy an investment simply because they think they will earn 20%.
7-8.A publicly traded company would care about its stock’s value in the market since future issuances of the stock by the company have the effect of lowering the market price of stock. If investors think they can earn a high return, they will sell their stock if they do not earn that return. A company may attempt to increase the investors’ return by paying more dividends to offset the decline in market value. Supply and demand tell us that if investors are selling their stock (making more available for purchase), the market price will drop. If the market price of stock declines, the financial health of a company appears weaker. When this happens, creditors may wish to charge a higher debt rate. Overall, the cost of capital of a company will rise.
7-9.A publicly traded company whose stock has decreased in value by $38 per share in one year will likely have a problem meeting analysts’ expectations in future periods (by missing a targeted EPS number) or by suffering from a public relations problem. Once word of this becomes public, investors become scared, and may sell their stock to avoid further declines in value. The company will not be viewed that highly by any investor.
NOTE TO INSTRUCTOR: Individual student responses to Discussion Questions 7-10 through 7-13 will vary from student to student, but will likely carry a common theme regardless of the specific question to which the student is responding. The answers will allude to some aspect beyond the immediate financial returns—perhaps anticipation of future financial profits, or some nonfinancial aspects that affect the community and the company as a whole.
7-10, 7-11, 7-12, and 7-13.
Companies may take on a capital project at a point equal to the blended cost of capital if management believed that there will be certain intangible elements not captured in the blended cost rate. For example, a new amusement park may be constructed when the expected rate of return is only forecasted to equal the blended cost of capital. However, if other companies are assessing the same area for amusement parks and other recreational activities of their own, the long-term expected rate of return could increase exponentially. The nonfinancial aspects associated with the acceptance could create customer goodwill and help stabilize the company’s financial health in the long run. A limitation of scarce resources is a common reason for not partaking in every profitable project that comes along.
7-14.Present value represents the discounted amount of the cash inflows or the discounted amount of the cash outflows. Net present value takes the difference of the discounted cash inflows and the discounted cash outflows to arrive at one net amount.
7-15.A company may often accept a project with a net present value of zero if there are ancillary opportunities that would result by commencing with the project. For example, a company may wish to ‘get its foot in the door’ in order to secure more profitable jobs from a particular company. A company may be attracted by the nonfinancial returns possible from accepting a zero NPV project.
7-16.Managers may compete for limited funding available for capital projects for many different reasons. Some managers enjoy the publicity of having their own project approved. A manager and his employees may be ridiculed by employees of other divisions when the project they hoped to have funded was not approved. Competition and pressures by others in the same division may cause unrealistic estimates to be placed in the proposals. The company's profits may suffer as a result.
One way to alleviate the “game” played by managers would be to establish a bonus system that rewards the manager whose project is approved only if the projections were accurate. At first some managers may still play the numbers game in order to have their projects funded. Subsequent estimates for additional projects would likely be more accurate once managers determine the actual reward is not simply getting the funding, but can result in personal compensation based on the accuracy of the estimate. This is only one of the many possibilities your students may come up to prevent circumventing the system.
REVIEW THE FACTS
A.The goals of a firm represent the purpose or purposes why an organization is formed. The goals of the firm define why the firm was established.
B.A mission statement is a summary of the main goals of the organization. The mission statement is often used to communicate the main goals of the firm.
C. The strategic plan is a long-range plan that sets forth the
actions a company will take to attain its organizational goals.
The strategic plan represents the what of doing business.
D.The capital budget outlines how a company intends to allocate its scarce resources over a five or 10-year, or even longer time period. The capital budget represents the how of the planning process.
E.The operating budget is the budget that plans a company’s routine day-to-day business activities for one to five years. The operating budget is the who of the planning process.
F.Capital investments are long-lived expensive items such as land, buildings, machinery, and equipment.
G.A capital investment refers to the long-lived asset itself. A capital project has four main characteristics. The first is that it will have a long life, second, a high cost, third, a quickly sunk cost and finally it has a high degree of risk associated with it.
H.The focus of the capital budget is on the long-term operations of the company to determine the allocation of resources over the long run, usually five, 10 or 20 years.
I.When the cost of a purchased item is capitalized the cost of the item is recorded as an asset on the balance sheet rather than an expense on the income statement.
J.When the cost of a purchased item is expensed the cost of the item is recorded as an expense on the income statement rather than as an asset on thebalance sheet.
K.The four shared characteristics of capital projects are:
1. long lives
2. high cost
3. quickly become sunk costs
4. high degree of risk
L.The cost of capital is also referred to as the cost of capital rate, the required rate of return, and the hurdle rate.
M.The net present value of an investment is the present value of cash inflows minus the present value of cash outflows associated with a capital budgeting project.
N.The profitability index helps one to select the best alternative among acceptable alternatives. The index is a tool that allows the ranking of acceptable capital projects.
O.The internal rate of return computation calculates the expected percentage promised by a proposed capital project.
P.The payback method is a technique that measures the length of time a capital project must generate positive cash flows that equal the original investment in the project.
Q.Two factors that lead to poor capital project selection are natural optimism (the tendency to overestimate cash inflows and underestimate cash outflows) and capital budgeting games (the tendency of management to underestimate the gravity of selecting a poor capital project),
R.Simple interest provides for the calculation of interest on the original investment only whereas compound interest provides for the calculation of interest on the principal amount invested plus all previously earned interest.
S.An annuity is a stream of equal periodic cash flows.
APPLY WHAT YOU HAVE LEARNED
7-17.
1. d Pertains to day-to-day activities.
2. c Pertains to the allocation of scarce resources.
3. a Consists of both financial and non-financial considerations.
4. a Stated in terms that are not easily quantified.
5. c,d Stated in terms that are easily quantified.
6. d Constitutes the who of business planning.
7. a Constitutes the why of business planning.
8. c Constitutes the how of business planning.
9. b Constitutes the what of business planning.
10. c Relates to long-lived, expensive assets.
7-18.
a.Debt = 1,400,000 = 58.333%
2,400,000
b.Equity =1,000,000 = 41.667%
2,400,000
c.Blended Cost of Capital:
Weighted
Rate % of Total Cost
Debt 8%58.333% 4.667%
Equity 18%41.667% 7.500%
Blended Cost of Capital12.167%
7-19.
a.Debt = _4,800,000_ = 25%
19,200,000
b.Equity = 14,400,000 = 75%
19,200,000
c.Blended Cost of Capital:
Weighted
Rate % of Total Cost
Debt 7% 25% 1.75%
Equity 22% 75%16.50%
Blended Cost of Capital18.25%
7-20.
a.Debt = _ 800,000_ = 32%
2,500,000
b.Equity = 1,700,000 = 68%
2,500,000
c.Blended Cost of Capital:
Weighted
Rate % of Total Cost
Debt 9% 32% 2.88%
Equity 20% 68%13.60%
Blended Cost of Capital16.48%
7-21.
a. 2 Identify alternative capital projects.
b. 1 Identify the need for a capital expenditure.
c. 4 Select a method for evaluating the alternatives.
d. 5 Evaluate the alternatives and select the project or
projects to be funded.
e. 3 Determine the relevant cash inflow and outflow information.
7-22.
0 1 2 3 4 5
|------|------|------|------|------|
–3,500 1,000 1,000 1,000 1,000 1,000
PVIFA (10%, 5 years) = 3.791 x $1,000 = $3,791
NPV = ($3,500) + $3,791 = $291 => Project meets requirements
7-23.
0 1 2 3 4 5
|------|------|------|------|------|
–4,000 1,200 1,200 1,200 1,200 1,200
PVIFA (12%, 5 years) = 3.605 x $1,200 = $4,326
NPV = ($4,000) + $4,326 = $326 => Project meets requirements
7-24.
0 1 2 3 4 5
|------|------|------|------|------|------
–97,000 22,500 22,500 22,500 22,500 22,500
6 7 8
|------|------|
22,500 22,500 22,500
PVIFA (14%, 8 years) = 4.639 x $22,500 = $104,378
NPV = ($97,000) + $104,378 = $7,378 => Project meets requirements.
7-25.
0 1 2 3 4 5
|------|------|------|------|------|------
–112,000 22,500 22,500 22,500 22,500 22,500
6 7 8
|------|------|
22,500 22,500 22,500
PVIFA (12%, 8 years) = 4.968 x $22,500 = $111,780
NPV = ($112,000) + $111,780 = ($220) => Project does not
meet requirements.
7-26.
0 1 2 3 4 5 6 7 8
|------|------|------|------|------|------|------|------|
-265,000 (Initial Investment)
Savings 62,000 62,000 62,000 62,000 62,000 62,000 62,000 62,000
a.
1.12% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$265,000 1.00 $(265,000)
PV of Savings 62,000 4.968 308,016
Net Present Value of Project $ 43,016
2.14% Present
Amount PVIF PVIFA Value
PV of Initial Investment – $265,000 1.00 $(265,000)
PV of Savings 62,000 4.639 287,618
Net Present Value of Project $ 22,618
3.16% Present
Amount PVIF PVIFA Value
PV of Initial Investment – $265,000 1.00 $(265,000)
PV of Savings 62,000 4.344269,328
Net Present Value of Project $ 4,328
b.Profitability Index = PV of Inflows
PV of Outflows
1.$308,016 = 1.16
$265,000
2.$287,618 = 1.09
$265,000
3.$269,328 = 1.02
$265,000
7-27.
0 1 2 3 4 5
|------|------|------|------|------|------
–3,600,000 (Initial Investment)
Savings 650,000 650,000 650,000 650,000 650,000
6 7 8 9 10
|------|------|------|------|
650,000 650,000 650,000 650,000 650,000
a.
1.10% Present
Amount PVIF PVIFA _ Value____
PV of Initial Investment –$3,600,000 1.00 $(3,600,000)
PV of Savings 650,000 6.145 3,994,250
Net Present Value of Project $ 394,250
2.12% Present
Amount PVIF PVIFA Value___
PV of Initial Investment –$3,600,000 1.00 $(3,600,000)
PV of Savings 650,000 5.650 3,672,500
Net Present Value of Project $ 72,500
3.14% Present
Amount PVIF PVIFA _ Value___
PV of Initial Investment –$3,600,000 1.00 $(3,600,000)
PV of Savings 360,000 5.216 3,390,400
Net Present Value of Project $ (209,600)
b.Profitability Index = PV of Inflows
PV of Outflows
1.$3,994,250 = 1.11
$3,600,000
2.$3,672,500 = 1.02
$3,600,000
3.$3,390,400 = .94
$3,600,000
7-28.
0 1 2 3 4 5 6 7 8
|------|------|------|------|------|------|------|------|
–5,500 1,400 1,400 1,4001,400 1,400 1,400 1,400 1,400
PVIFA (16%, 8 years) = 4.344 x $1,400 = $6,081.60
NPV = ($5,500) + $6,081.60 = $581.60 => Project meets requirements
7-29.
0 12 3 4 5 67 8 9 10
|------|------|------|------|------|------|------|------|------|------|
–25,800 4,400 4,400 4,400 4,400 4,400 4,400 4,400 4,400 4,400 4,400
PVIFA (14%, 10 years) = 5.216 x $4,400 = $22,950.40
NPV = ($25,800) + $22,950.40 = $(2,849.60) => Project does not meet requirements
7-30.
0 1 2 3 4 5
|------|------|------|------|------|
–35,000
Savings 8,500 8,500 8,500 8,500 8,500
Residual Value 2,000
PVIFA (14%, 5 years) = 3.433 x $8,500 = $29,181
PVIF (14%, 5 years) = . 519 x $2,000 = $1,038
NPV = ($35,000) + $29,181 + $1,038 = ($4,781) => Project does not meet requirements
7-31.
0 1 2 3 4 5 6
|------|------|------|------|------|------|
–6,500
Savings 1,500 1,500 1,500 1,500 1,500 1,500
Residual Value 1,000
PVIFA (16%, 6 years) = 3.685 x $1,500 = $5,528
PVIF (16%, 6 years) = .410 x $1,000 = $410
NPV = ($6,500) + $5,528 + $410 = ($562) => Project does not meet requirements
7-32.
0 1 2 3 4 5 6 7
|------|------|------|------|------|------|------|
–78,500
Savings 19,500 19,500 19,500 19,500 19,500 19,500 19,500
Residual Value 4,000
PVIFA (16%, 7 years) = 4.039 x $19,500 = $78,761
PVIF (16%, 7 years) = .354 x $4,000 = $1,416
NPV = ($78,500) + $78,761 + $1,416 = $1,677 => Project meets requirements
7-33.
0 1 2 3 4 5 6 7 8
|------|------|------|------|------|------|------|------|
–58,000
Savings 11,500 11,500 11,500 11,500 11,500 11,500 11,500 11,500
Residual Value 2,000
PVIFA (12%, 8 years) = 4.968 x $11,500 = $57,132
PVIF (12%, 8 years) = .404 x $2,000 = $808
NPV = ($58,000) + $57,132 + $808 = $(60) => Project does not meet requirements
7-34.
0 1 2 3 4 5 6 7
|------|------|------|------|------|------|------|
–68,000 (Initial Investment)
Savings 17,000 17,000 17,000 17,000 17,000 17,000 17,000 Residual Value 5,000
a.
1.12%Present
Amount PVIF PVIFA Value
PV of Initial Investment –$68,000 1.00$(68,000)
PV of Savings 17,000 4.564 77,588
PV of Residual Value 5,000 .452 2,260
Net Present Value of Project$ 11,848
2.14% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$68,000 1.00$(68,000)
PV of Savings 17,000 4.288 72,896
PV of Residual Value 5,000 .400 2,000
Net Present Value of Project$ 6,896
3.16% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$68,000 1.00$(68,000)
PV of Savings 17,000 4.039 68,663
PV of Residual Value 5,000 .354 1,770
Net Present Value of Project$ 2,433
b.Profitability Index = PV of Inflows
PV of Outflows
1.$79,848 = 1.17
$68,000
2.$74,896 = 1.10
$68,000
3.$70,433 = 1.04
$68,000
7-35.
1 2 3 4 5 6 7 8 9 10
|------|------|------|------|------|------|------|------|------|------|
-248,000 (Initial Investment)
Savings 45,000 ------per year------45,000 Residual Value 25,000
a.
1.10% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$248,000 1.00 $(248,000)
PV of Savings 45,000 6.145 276,525
PV of Residual Value 25,000 .386 9,650
Net Present Value of Project $ 38,175
2.12% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$248,000 1.00 $(248,000)
PV of Savings 45,000 5.650 254,250
PV of Residual Value 25,000 .322 8,050
Net Present Value of Project $ 14,300
3.14% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$248,000 1.00 $(248,000)
PV of Savings 45,000 5.216 234,720
PV of Residual Value 25,000 .270 6,750
Net Present Value of Project $ (6,530)
b.Profitability Index = PV of Inflows
PV of Outflows
1. $286,175 = 1.15
$248,000
2.$262,300 = 1.06
$248,000
3.$241,470 = .97
$248,000
7-36.
0 1 2 3 4 5 6 7 8
|------|------|------|------|------|------|------|------|
–78,000
Savings 18,000------per year------18,000
Residual Value 5,000
a.
1.12% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$78,000 1.00 $(78,000)
PV of Savings 18,000 4.968 89,424
PV of Residual Value 5,000 .404 2,020
Net Present Value of Project$ 13,444
2.14% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$78,000 1.00 $(78,000)
PV of Savings 18,000 4.639 83,502
PV of Residual Value 5,000 .351 1,755
Net Present Value of Project$ 7,257
3.16% Present
Amount PVIF PVIFA Value
PV of Initial Investment –$78,000 1.00 $(78,000)
PV of Savings 18,000 4.344 78,192
PV of Residual Value 5,000 .305 1,525
Net Present Value of Project$ 1,717
b.Profitability Index = PV of Inflows
PV of Outflows
1. $91,444 = 1.17
$78,000
2.$85,257 = 1.09
$78,000
3.$79,717 = 1.02
$78,000
7-37.
Internal Rate of Return = Initial Outlay
Annual Cash Savings
a.$18,023.88 = 3.604776 => PVIFA for 5 years at 12%
$5,000.00
b. (1)When the cost of capital is 9%, this project is acceptable.
(2)When the cost of capital is 11%, this project is acceptable.
(3)When the cost of capital is 13%, this project is NOT acceptable.
(4)When the cost of capital is 15%, this project is NOT acceptable.
7-38.
Internal Rate of Return = Initial Outlay
Annual Cash Savings
a.$51,590 = 3.685 => PVIFA for 6 years at 16%
$14,000
b. (1)When the cost of capital is 14%, this project is acceptable.
(2)When the cost of capital is 16%, this project is acceptable.
(3)When the cost of capital is 18%, this project is NOT acceptable.
Chapter M7 – The Capital Budget: Evaluating Capital Expenditures M7-1
7-39.
a.ABC
Initial Outlay$18,023.88$22,744.12$24,031.57
Annual Savings 5,000.00 6,000.00 7,000.00
Calculated PVIFA 3.604776 3.790787 3.433081
Rate of Return 12%10%14%
b.Project C has the highest rate of return at 14%.
7-40.
a.ABC
Initial Outlay$14,909.92$18,555.46$26,674.63
Annual Savings 3,000.00 4,000.00 5,000.00
Calculated PVIFA 4.96764 4.63886 5.33493
Rate of Return 12%14%10%
b.Project B has the highest rate of return at 14%.
7-41.
0 1 2 9 10
|------|------|-->--|------|
Initial Outlay –1,449,968.24
Annual Savings 300,000 300,000 300,000 300,000
([$1.50 – $0.90) x 500,000)
Residual Value -0-
a.Net Present Value
1.12%Amount PVIF PVIFA Present Value
PV-Initial Investment –1,564,580.00 1.00 $(1,564,580.00)
PV-Savings 300,000.00 5.650 1,695,000.00
PV-Residual Value -0- -0-