Practice Problems Ch12

Practice Problems Chapter 12 Problems 12-1.
Corporate cash flow Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 30% Earnings aftertaxes Amortization Cash flow $ 90,000 40,000 50,000 15,000 35,000 + 40,000 $ 75,000
Alternative cash flow calculation: $90,000 15,000 (taxes) $75,000 cash flow 12-2. a. Corporate cash flow Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 30% Earnings aftertaxes Amortization Cash flow $ 90,000 10,000 80,000 24,000 56,000 + 10,000 $ 66,000
b. Cash flow (problem 1) $75,000 or [$40,000 $10,000](T) Cash flow (problem 2a) 66,000 = 30,000 (.3) Difference in cash flow $ 9,000 = $9,000
Foundations of Fin. Mgt.
S-364
8/E Cdn. Block, Hirt, Short
12-3.
Blink 281 Corporation a. Average accounting return ( AAR ) =
Average earnings aftertax Average book value

Taxes $7,600 8,400 10,000 11,600 13,600 EAT $11,400 12,600 15,000 17,400 20,400 76,800 $15,360
Year EBAT 1 $35,000 2 37,000 3 41,000 4 45,000 5 50,000
Amortization $16,000 16,000 16,000 16,000 16,000
EBT $19,000 21,000 25,000 29,000 34,000
Average earnings aftertax
Average accounting return ( AAR ) =
$15,360 = 0.3840 = 38.4% $80,000 / 2
b. Seems like a pretty good return, but we need a criteria for acceptance of projects. What AAR is enough? c. AAR does not use the time value of money, cash flows or the market value of assets. 12-4. Year EBAT 1 $110,000 2 120,000 3 150,000 Amortization $70,000 70,000 70,000 Pluto Corporation EBT $40,000 50,000 80,000 Taxes $16,000 20,000 32,000 EAT $24,000 30,000 48,000 102,000 $34,000
Average accounting return ( AAR ) =
$34,000 = 0.3238 = 32.38% $210,000 / 2
S-365
12-5.
Al Quick
Being short term oriented, he may make the mistake of turning down the project even though it will increase cash flow because of his fear of investors negative reaction to the more widely reported quarterly decline in earnings per share. Even though this decline will be temporary, investors might interpret it as a negative signal. 12-6. Year EBAT 1 $110,000 2 120,000 3 150,000 Amortization $70,000 70,000 70,000 Pluto Corporation EBT $40,000 50,000 80,000 Taxes $16,000 20,000 32,000 EAT $24,000 30,000 48,000 102,000 $34,000
Average accounting return (AAR ) =
$34,000 = 0.3238 = 32.38% ($210,000 + 0) / 2
12-7. Payback for Investment X $40,000 $ 6,000 34,000 8,000 26,000 9,000 17,000 17,000 1 year 2 years 3 years 4 years
Payback Payback for Investment Y $40,000 $15,000 25,000 20,000 5,000/ 10,000 1 year 2 years 2.5 years
Payback: Investment X = 4.00 years Payback: Investment Y = 2.5 years Investment Y would be selected because of the faster payback.
S-366
12-8.
Payback Revisited
The $20,000,000 inflow would still leave the payback period for Investment X at 4 years. It would remain inferior to Investment Y under the payback method.
12-9.
Payback versus NPV NPV for Investment X Year 1 2 3 4 5 Cash flow $ 6,000 8,000 9,000 17,000 20,000 Present value of inflows Initial investment NPV (net present value) Present value @ 15% $ 5,217 6,049 5,918 9,720 9,944 $36,848 40,000 $(3,152)
NPV for Investment Y Year 1 2 3 Cash flow $15,000 20,000 10,000 Present value of inflows Initial investment NPV (net present value) Present value @ 15% $13,043 15,123 6,575 $34,741 40,000 $(5,259)
Neither project is attractive, with investment Y less attractive.
S-367
12-10.
Boardwalk Company Payback for St. Charles $90,000 $10,000 80,000 10,000 70,000 10,000 60,000 60,000 1 year 2 years 3 years 4 years
a. Payback for Reading Railway Place $90,000 $60,000 30,000 10,000 20,000 10,000 10,000 10,000 1 year 2 years 3 years 4 years
Both projects have equal payback = 4.00 years b. Reading Railway with a $60,000 payback in year 1 is preferred to St.
Charles with its $60,000 payback in year 4, when we consider the time value of money.
12-11.
Diaz Camera Company Payback for Project B $10,000 $5,000 5,000 3,000 2,000 / 8,000 1 year 2 years 2.25
a. Payback for Project A $10,000 $6,000 4,000 4,000 years Choose project A b. NPV for Project A Year Cash flow 1 $6,000 2 4,000 3 3,000 Present value of inflows Initial investment NPV (net present value) 1 year 2 years
Present value @ 10% $5,455 3,306 2,254 $11,015 10,000 $ 1,015
S-368
NPV for Project B Year Cash flow 1 $5,000 2 3,000 3 8,000 Present value of inflows Initial investment NPV (net present value)
Present value @ 10% $4,545 2,479 6,011 $13,035 10,000 $ 3,035
Both projects are attractive, but project B adds the most value to the firm. It has the higher NPV. c. The NPV is preferred and gives more confidence because it incorporates the time value of money and considers all the cash flows.
12-12.
Hand Salsa
PV $11,778 = = 5.889 ( Appendix D) A $2,000 For N = 10, we find 5.889 under the 11% column. Therefore IRR = 11% PVIFA =
Calculator: Compute: PV = $11,778 N = 10 %i = 11.00% FV = 0 %i =? PMT = $2,000
S-369
12-13.
Generation Thumbs
Calculator: Compute: 12-14. PV = $16,980 N = 12 %i = 14.00% FV = 0 %i =? PMT = $3,000
Warner Business Products
Calculator: Compute: PV = $11,070 N=8 %i= 9.00% FV = 0 %i =? PMT = $2,000
The machine should not be purchased since its return is under 13%. 12-15. a. Year 1 2 3 Home Security Systems Cash flow $20,000 18,000 13,000 Present value of inflows Initial investment NPV (net present value) PV @ 14% @15% $17,544 17,391 13,850 13,611 8,775 8,548 $40,169 $39,550 40,000 40,000 $ 169 $ (450)
IRR is the discount rate at which the NPV = 0. This is a trial and error process. In this case IRR is between 14% and 15% (14% + 169/ 619 1% = 14.27%)
S-370
b. Year 1 2 3
Cash flow $20,000 18,000 13,000 Present value of inflows Initial investment NPV (net present value)
Present value @ 12% $17,857 14,349 9,253 $41,459 40,000 $ 1,459
The machine should be purchased as the NPV is positive. c. Profitability index =
PV of inflows $41,459 = = 1.04 PV of outflows $40,000
12-16. Year 1 2 3 4 5
Aerospace Dynamics Cash flow $36,000 44,000 38,000 (44,000) 81,000 Present value of inflows Present value of outflows NPV(net present value) Present value @ 11% $32,432 35,711 27,785 (28,984) 48,070 $115,014 110,000 $ 5,014
The NPV is positive and the project should be undertaken.
S-371
12-17. Year 1 2 3 3
Horizon Corporation Cash flow Present value @ 10% $15,000 $13,636 25,000 20,661 40,000 30,053 (10,000) (7,513) Present value of inflows $56,837 Present value of time zero outflow 60,000 Net present value $(3,163)
The NPV is negative. The project should not be undertaken. Note, the $10,000 outflow could have been subtracted out of the $40,000 inflow in the third year and the same answer would result.
12-18.
Skyline Corporation
Find the present value of a deferred annuity: PVA = A PVIFA (n = 10, i = 12%) (Appendix D) PVA = $34,000 5.650 = $192,100 Calculator: Compute: PV =? FV = 0 PMT = $34,000 N = 10 %i = 12% PV = $192,108
Discount this value to PV from the beginning of the third period (end of 2nd).
PV = FV PVIF (n = 2, i = 12%) (Appendix B) PV = $192,100 .797 = $153,104 Calculator: Compute: PV =? FV = $192,108 N=2 %i = 12% PV = $153,147
$153,147 130,000 $ 23,147
PMT = 0
Present value of inflows Present value of outflows NPV (net present value)
Undertake project!
S-372
12-19. a. NPV Year 1 2 3 4 5
Ogden Corporation Cash flow Present value @ 9% $ 5,000 $ 4,587 5,000 4,208 8,000 6,177 9,000 6,376 10,000 6,499 Present value of inflows $27,847 Present value of outflows (cost) 25,000 NPV (net present value) $ 2,847
b. IRR
Since we have a positive net present value, the internal rate of return must be larger than 9%. Because of uneven cash flows, we need to use trial and error. Counting the net present value calculation as the first trial, we now try 11% for our second trial.
Year 1 2 3 4 5
Cash flow $ 5,000 5,000 8,000 9,000 10,000 Present value of inflows
Present value @ 11% $ 4,505 4,058 5,850 5,929 5,935 $26,277
A two percent increase in the discount rate has eliminated over one-half of the net present value so another two percent should be close to the answer.
Year 1 2 3 4 5
Cash flow $ 5,000 5,000 8,000 9,000 10,000 Present value of inflows
Present value @13% $ 4,425 3,916 5,544 5,520 5,428 $24,833
S-373
The correct answer must fall between 11% and 13%. We interpolate. $26,277 24,833 $ 1,444 PV @ 11% PV @ 13% $26,277 25,000 $ 1,277 PV @ 11% (Cost)
IRR (interpolate ) = 0.11 +
$1,277 (0.02) = 0.11 + 0.884(0.02) $1,444 = 0.11 + .0177 = 0.1277 = 12.77%

= 25,000; 5,000; 5,000; 8,000; 9,000;
Calculator: 10,000 Compute:
Cfi
n=5 %i =? IRR = 12.76%
c. The project should be accepted because the NPV is positive and the IRR exceeds the cost of capital.
S-374
12-20.
Adventures Club, Inc.
NPV for Project X (Disneyland) Year Cash flow Present value @ 12% 1 $4,000 $ 3,571 2 5,000 3,986 3 4,200 2,989 4 3,600 2,288 Present value of inflows 12,834 Present value of outflows (cost) 10,000 NPV (net present value) $ 2,834
Profitability index =
NPV for Project Y (Film Festivals) Year Cash flow Present value @ 12% 1 $10,800 $ 9,643 2 9,600 7,653 3 6,000 4,271 4 7,000 4,449 Present value of inflows $26,016 Present value of outflows (cost) 22,000 NPV (net present value) $ 4,016
Profitability index =
You should select Project X because it has the higher profitability index. This is true in spite of the fact that it has a lower net present value. The profitability index may be appropriate when you have different size investments. What can be earned on the differential investment of $12,000 (between projects) may be relevant.
S-375
12-21.
Cablevision, Inc.
a. Reinvestment assumption of NPV Year 1 2 3 4 5 Inflows $10,000 10,000 16,000 19,000 20,000 Rate 9% 9% 9% 9% No. of Periods 4 3 2 1 0 Future value $14,116 12,950 19,010 20,710 20,000 $86,786
b. Reinvestment assumption of IRR Year 1 2 3 4 5 Inflows $10,000 10,000 16,000 19,000 20,000 Rate 15% 15% 15% 15% No. of Periods 4 3 2 1 0 Future value $17,490 15,209 21,160 21,850 20,000 $95,709
c. No. However, for investments with a very high IRR, it may be unrealistic to assume that reinvestment can take place at an equally high rate. The net present value method makes the more conservative assumption of reinvestment at the cost of capital.
S-376
12-22. a. Year 1 2 3
Last Century Corporation
Inflows $12,000 10,000 7,200
Rate 7% 7% 7%
# of Periods 2 1 0 Terminal value
Future value $13,739 10,700 7,200 $31,639
PVIF =
PV $25,000 = = 0.790 (Appendix B) FV $31,639
At 3 periods, appendix B suggests a modified IRR of 8%
Calculator: Compute:
PV = $25,000 FV = $31,639 N=3 %i = ? %i = 8.17%
PMT = 0
b. Calculator: CFi = 25,000; 12,000; 10,000; 7,200 Compute: IRR = 8.96%
%i = ?
The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the lower cost of capital.
S-377
12-23. a. Year 1 2 3
Music Box Rentals
Inflows $16,000 12,300 15,100
Rate 10% 10% 10%
Future value $19,360 13,530 15,100 $47,990
PVIF =
PV $39,000 = = 0.813 (Appendix B) FV $47,990
PV = $39,000 FV = $47,990 N=3 %i = ? %i = 7.16%
PMT = 0
%i = ?
The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the higher cost of capital.
S-378
12-24.
Caffeine Coffee Company
a. Year 1 2 3
Inflows $15,000 12,000 9,000
Rate 12% 12% 12%
Future value $18,816 13,440 9,000 $41,256
PVIF =
PV $27,000 = = 0.654 (Appendix B) FV $41,256
PV = $27,000 FV = $41,256 N=3 %i = ? %i = 15.18%
PMT = 0
%i = ?
The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the lower cost of capital.
S-379
12-25.
Oliver Stone and Rock Company
You should rank the investments in terms of IRR. Project E B G H D A F C IRR 21% 19.0 18.0 17.5 16.5 14.0 11.0 10.0 Project Size $20,000 25,000 25,000 10,000 25,000 15,000 15,000 30,000 Total Budget $ 20,000 45,000 70,000 80,000 105,000 120,000 135,000 165,000
a. Because of capital rationing, only $80,000 worth of projects can be

accepted. The four projects to accept are E, B, G and H. Projects D and A provide positive benefits also, but cannot be undertaken under capital rationing.
b. If Projects B and G are mutually exclusive, you would select Project B in

preference to G. In summary, you would accept E, B, H and D. The last project would replace G and is of the same $25,000 magnitude.
12-26. 12-27.
Miller Electronics Software Systems Outflow $20,000
a. NPV @ 0% discount rate Inflows $5,800 = (11,000 + $9,000 + $5,800) b. 10% discount rate Year 1 2
Cash Flow $11,000 9,000

S-380
Present Value @ 10% $10,000 7,438

5,800 Present value of inflows Present value of outflows NPV (net present value)
4,358 21,796 20,000 $ 1,796
c. 20% discount rate Year 1 2 3 Cash Flow $11,000 9,000 5,800 Present value of inflows Present value of outflows Net Present Value Present Value @ 20% $ 9,167 6,250 3,356 18,773 20,000 $(1,227)
S-381
d. Net present value profile
e. Interpolate between 15% and 16%: Year 1 2 3 Year 1 2 3 Cash Flow $11,000 9,000 5,800 Present value of inflows Cash Flow $11,000 9,000 5,800 Present value of inflows Present Value @ 15% $ 9,565 6,805 3,814 $20,184 Present Value @ 16% $ 9,483 6,688 3,716 $19,887
S-382
$20,184 19,887 $ 297
PV @ 15% PV @ 16%
$20,184 20,000 $ 184
PV @ 15% (Cost)
IRR (interpolatation ) = 0.15 +
$184 (0.01) = 0.15 + 0.62(0.01) $297 = 0.15 + .0062 = 0.1562 = 15.62%
Calculator: Cfi = 20,000; 11,000; 9,000; 5,800 N=3 %i =? Compute: IRR = 15.62%
S-383
12-28.
Zebra Corporation
a. The original cost of the building would be deducted from the Class 3 pool as the lower of sale price or original cost is used when disposing of an asset. The Class 3 UCC is: $12,000,000 4,500,000 $ 7,500,000 The present value of the tax shield lost on disposal would be: Salvage d Tc/ (d + r) = $4,500,000 .05 .40/ (.05 + .12) = $4,500,000 .1176471 = $529,412
The $500,000 difference ($5,000,000 $4,500,000) would be a capital gain for tax purposes. Fifty percent of a capital gain is taxable. Zebras tax on the taxable capital gain is:
0.50 capital gain T PVIF (n = 1, i = 12%) = 0.50 $500,000 .4 PVIF (n = 1, i = 12%) = $89,286 The total present value of tax consequences = $529,412 + $89,286 = b. Class 3 UCC $4,000,000 4,500,000 $ (500,000) $618,698
The negative balance of $500,000 is recaptured amortization. This is added to income in the year of disposal thus increasing tax by:
Income increase T PVIF (n = 1, i = 12%) = $500,000 0.4 PVIF (n = 1, i = 12%) = $178,571
S-384
The present value of the tax shield lost on disposal would be: Salvage d Tc / (d + r) = $4,000,000 .05 .40 / (.05 + .12) = $4,000,000 .1176471 = $470,588
Since there was only $4,000,000 in the pool, that is the basis for calculating the tax shield lost on disposal. The tax on the taxable capital gain is $89,286 (as in part a).
The total present value of tax consequences = $178,571 + $470,588 + $89,286 = c. Class 3 UCC $6,000,000 4,500,000 $1,500,000
$738,445
The $1,500,000 left over in the Class 3 pool is a terminal loss and can be written off against income in the year of disposal. The tax savings is: Terminal loss T PVIF (n = 1, i = 12%) = $1,500,000 .4 PVIF (n = 1, i = 12%) = $535,714 The present value of the tax shield lost on disposal would be: Amount in pool = $6,000,000 = $6,000,000 = $705,882 d Tc/ (d + r) .05 .40 / (.05 + .12) .1176471
The tax on the taxable capital gain is $89,286 (as in part a). The total present value of tax consequences = $(535,714) + $705,882 + $89,286 = $259,454
S-385
12-29.
Capital Cost Allowance
a. The assets will fall under Class 10 (auto equipment) with an allowable CCA rate of 30%.
b. Year 1 Increase in pools UCC Allowable CCA in 1st year Year 2 Remaining increase in UCC Additional CCA allowable
= $95,000 = 1/2 ($95,000 .30) = $14,250 = = = = $95,000 $14,250 $80,750 $80,750 .30 $24,225
c. The assets would then fall under Class 8 (machinery): The allowable CCA rate would be 20%. d. There would be no effects except to the extent of any dollar amounts realized on disposal.
S-386
12-30.
Coastal Shipping Corporation
a. The original cost of the vessel would be deducted from the Class 7 pool as the lower of sale price or original cost is used when disposing of an asset. The Class 7 UCC is: $2,000,000 1,000,000 $1,000,000 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage) dTc / (d + r) = $1,000,000 .15 .40 / (.15 + .10) = $1,000,000 .240 = $240,000 This is the extent of the tax consequences. b. Class 3 UCC $ 800,000 1,000,000 $ (200,000)
The negative balance of $200,000 is recaptured amortization. This is added to income in the year of disposal increasing tax by: Income increase T PVIF (n = 1, i = 10%) = $200,000 .4 PVIF (n = 1, i = 10%) = $72,727 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage) dTc / (d + r) = $800,000 .15 .40 / (.15 + .10) = $800,000 .240 = $192,000 Since there was only $800,000 in the pool, that is the basis for calculating the tax shield lost on disposal.
S-387
The total present value of tax consequences = $72,727 + $192,000 = c. Class 3 UCC $ 600,000 1,000,000 $(400,000)
$264,727
The negative balance of $400,000 is recaptured amortization. This is added to income in the year of disposal thus increasing tax by: Income increase T PVIF (n = 1, i = 10%) = $400,000 .4 PVIF (n = 1, i = 10%) = $145,454 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage) dTc / (d + r) = $600,000 .15 .40 / (.15 + .10) = $600,000 .240 = $144,000 Since there was only $600,000 in the pool, that is the basis for calculating the tax shield lost on disposal. The total present value of tax consequences = $145,454 + $144,000 = $289,454
S-388
12-31.
Nexus Corp.
a. The CCA class for aircraft is Class 9, with a CCA rate of 25%. b. CCA allowable in 1st year $1,500,000 25% .5
$187,500
CCA allowable in 2nd year [$1,500,000 $187,500] 25% =
$328,125
c. The CCA class for hangars is class 6, with a CCA rate of 10%. d. After 10 years the UCC of Class 9 will be(including CCA for the 10th year): $1,500,000[1 (.25/2) (1 .25)10 1] = $1,500,000 [(.875) (.75)9] = $1,500,000 [.0656991] = $98,549 If the plane is scrapped after the 10th year the consequences are: Recapture of $200,000 98,549 $101,451
Thus $101,451 will be added to taxable income in the eleventh year. To determine the taxes payable: multiple by Nexus tax rate.
S-389
12-32.
Thorpe Corporation Increased sales Increased costs Earnings before amortization and taxes Amortization ($50,000 .20 1/2) Earnings before taxes Taxes @ 38% Earnings aftertax Amortization Net cash flow $80,000 45,000 35,000 5,000 30,000 11,400 18,600 5,000 $23,600
12-33.
Cellular Spacephones Ltd.
a. The investment qualifies for a 35% ITC. $1,700,000 .35 = $595,000 b. The original cost base is: $1,700,000 $595,000 = $1,105,000
c. The effects of ITC and CCA are realized at year-end. Therefore: PV (ITC) = ITC PVIF (n = 1, i = 10%) = $595,000 PVIF (n = 1, i = 10%) = $540,909
dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r .20 .22 1 + .5 .10 = [$1,105,000] = $154,700 .10 + .20 1 + .10
Total combined present value of tax benefits is: = $540,909 + $154,700 =
$695,609
S-390
12-34. a.
Medicine Hat Enterprises Tax shield CCA @ 43% $12,500 $ 5,375 23,750 10,213 21,375 15,000 36,375 15,641 47,738 20,527 42,964 20,000 62,964 27,075
(Beginning) Year UCC Purchases Sales Rate 0 0 $250,000 (.10)(.50) 1 $237,500 (.10) 2 213,750 (.10) 300,000 (.10)(.50) 3 4 477,375 429,637 400,000 (.10) (.10) (.10)(.50)
This year 766,673 400,000 Remaining UCC 366,673 This is a Terminal loss Resulting in a tax savings of $366,673 0.43 = b. As in (a) only no terminal loss.
157,669
c. CCA lost from this year forward on $400,000, but $366,673 remains in the pool. Tax shield Present value @ 13% $ 5,375 $ 4,757 10,213 7,998 15,641 10,840 20,527 12,590 27,075 14,695 Present value of tax shields $50,880 (without terminal loss) Terminal loss 157,669 85,576 $166,456 Year 1 2 3 4 5
S-391
With formula: PV of impacts on pool: Year Purchase/ sell 0 $250,000 2 300,000 4 400,000 5 (400,000)
PV @ 13% $250,000 234,944 245,327 (217,104) $513,167
dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r 0.10 0.43 1 + .5 .13 = [$513,167] 0.13 + 0.10 1 + .13 = [$513,167](0.1869565)(0.942478)
= $90,421
Difference between formula and year by year calculation: = $90,421 $50,880 = $39,541 Without formula $766,673 remains in the pool before $400,000 sale. 0.10 0.43 1 + .5 .13 0.10 0.43 PV (CCA) = [$766,673] [$400,000] 0.13 + 0.10 1 + .13 0.13 + 0.10 = [$766,673](.1869565) $400,000(0.17620239)
= $143,335 $70,481
PV = = $72,854 PVIF (n = 5, %i = 13) $39,542 (rounding difference) PV =? FV = $72,854 N=5 %i = 13% PV = $39,542
= $72,854
Note:
PMT = 0
The half year rule has already been applied to arrive at the $766,673.
S-392
12-35. n=2
Elite Car Rental Corporation T = 40% r = 12% Expected Cash Flow d = 40% (class 16) Aftertax Cash Flow Present Value @ 12% $(900,000) ( 10,000) 319,420 (170,357) 430,485 7,972
Year 0 0 1-2 1-2 2 2 0
Event
Investment $(900,000) Working capital (10,000) Revenue $10,500 30 = 315,000 189,000 Expenses $0.14(40,000) 30 = 168,000 100,800 Sale (.60) (900,000) = 540,000 WC recovery 10,000 CCA pool dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r
0.40 0.40 1 + .5 .12 = [$900,000 $430,485] 0.12 + 0.40 1 + .12 = [$469,515](0.3076923)(0.9464286) = 136,727
NPV = $(185,753) Elite Car Rental Corporation should not purchase the autos as the firms value will decrease by $185,753.
S-393
12-36. n=9 T = 23%
Albert I. Stein Ltd. r = 13% d = 20% (class 8) ITC = 20%
S-394
12-37. n=5 Year 0 0 1 1 2 3 4 5 0 Event Investment Trade- in ITC Cost savings Cost savings Cost savings Cost savings Cost savings CCA pool T = 44%
Pierce Labs r = 12% Expected Cash Flow $(390,000) 85,000 .15(390,000) = 58,500 99,000 88,000 77,000 66,000 55,000 d = 20% (class 8) ITC = 15% Aftertax Cash Flow 55,440 49,280 43,120 36,960 30,800 Present Value @ 12% $(390,000) 85,000 52,232 49,500 39,286 30,692 23,489 17,477
dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r 0.20 0.44 1 + .5 .12 = [$390,000 $85,000] 0.12 + 0.20 1 + .12 = [$305,000](0.2750)(0.94642857) = 79,382 1 ITC from CCA pool dT 0.20 0.44 PV (CCA) = [- ITC PV ] C = [ $58,500] r+d 0.12 + 0.20 (14,364) = [ $58,500](0.2750) = ($16,088)
NPV = $(27,306) Pierce Labs should not purchase the new machine.
S-395
Comprehensive Problems 12-38.

Year EBIT - Interest = EBT 1 $650,000 $93,750 $556,250 2 $700,000 $93,750 $606,250 3 $720,000 $93,750 $626,250
4 $720,000 5 $690,000 6-10 $700,000 $93,750 $93,750 $93,750 $626,250 $596,250 $606,250
Ontario Corporation
Tax (46%) $255,875 $278,875 $288,075
$288,075 $274,275 $278,875
Net = Income $300,375 $327,375 $338,175

$338,175 $321,975 $327,375
+ Amort. $140,000 $140,000 $140,000

$140,000 $140,000 $140,000
Capital - Investment $200,000 $200,000 $200,000

$200,000 $200,000 $ 80,000
Cash = Flow $240,375 $267,375 $278,175

$278,175 $261,975 $387,375
*PV of Cash Flow $ 212,721 $ 209,394 $ 192,789

$ 170,609 $ 142,190 $ 739,504 $1,667,207
*13% was used since this is an equity only investment. From the table we see that the present value of the cash flows estimates for the next ten years is $1,667,207. We must now calculate a value for the cash flows expected more than 10 years hence. To do this we will calculate a terminal value at the end of year 10 and discount that back to the present. Terminal value = = = = = Annual cash flow/ discount rate $387,375/ 0.13 $2,979,808 $2,979,808 x PVIF (n = 10, i = 13%) $877,817
Present value
Therefore, the present value of all future cash flow estimates is $1,667,207 + $877,817 = $2,545,024 Since the market value of the firms shares is $3,000,000 (2,000,000 $1.50/share) there seems little point in Ontario pursuing Target Firm if management is reasonably confident in the assumptions underlying the analysis.
S-396
12-39. n = 10 a. Year 0 0 1-10 10 0 Event
Signs For Fields Machinery Ltd. T = 39% r = 15% Expected Cash Flow d = 20% Aftertax Cash Flow Present Value @ 15% $(65,000) ( 7,000) 53,575 2,843
Purchase machine $(65,000) Installation (7,000) Cost savings 17,500 10,675 Salvage 11,500 CCA pool dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r
0.20 0.39 1 + .5 .15 = [$65,000 + $7000 $2,843] 0.15 + 0.20 1 + .15 = [$69,157](0.22285714)(0.9347826) = 14,407 NPV = $( 1,175)
Signs For Fields Machinery should not purchase the new machine. b. Sell old machine Remove from CCA pool: 9,000 (.208323) Net increase in NPV Overall the new $ 9,000 (1,875) 7,125 NPV = $ 5,950
Signs For Fields Machinery should now purchase the new machine.
S-397
c. Year 0 0 1-10 10 0
Event
Expected Cash Flow
Aftertax Cash Flow
Present Value @ 14% $(65,000) ( 7,000) 55,682 3,102
Purchase machine $(65,000) Installation (7,000) Cost savings 17,500 10,675 Salvage 11,500 CCA pool dT 1 + .5r PV (CCA) = [C - S PV ] C r + d 1 + r
0.20 0.39 1 + .5 .14 = [$65,000 + $7000 $3,102] 0.14 + 0.20 1 + .14 = [$68,898](0.22941176)(0.93859649) = 14,835 NPV = $ 1,619
$1,619 (1,175) $2,794 PV @ 14% PV @ 15% $1,619 0,000 $1,619 PV @ 14% (Cost)
$1,619 (0.01) = 0.14 + 0.579(0.01) $2,794 = 0.14 + .0058 = 0.1458 = 14.58%

Profitability index(PI ) =
S-398
12-40. n=7 OuOu Year 0 1-7 7 Event
H. Improvements Ltd. T = 44% r = 14% d = 30% Present Value @ 14%
Expected Cash Flow
Aftertax Cash Flow
$(50,000) (10,920) (46,828) 2,398 0.30 0.44 1 + .5 .14 PV (CCA) = [$50,000 $2,398] 0.14 + 0.30 1 + .14 = [$47,602](0.30)(0.93859649) = 13,404 NPV = $(81,026) Expected Cash Flow Aftertax Cash Flow Present Value @ 14%
Purchase machine $(50,000) Operating costs (19,500) Salvage 6,000
Major OuOu Year Event 0 1-7 7
$(69,000) (7,280) (31,219) 3,197 0.30 0.44 1 + .5 .14 PV (CCA) = [$69,000 $3,197] 0.14 + 0.30 1 + .14 = [$65,803](0.30)(0.93859649) = 18,529 NPV = $(78,493) The salvage value of $4,500 for the old machine would be deducted from the CCA pool, but since it is common to both alternatives it is ignored for the analysis and decision making purposes. The Major OuOu should be selected as its NPV is less costly. Our assumption is that the revenue stream is worthwhile and the least costly replacement is to be selected.
Purchase machine $(69,000) Operating costs (13,000) Salvage 8,000
S-399
12-41. n=8 a. Year 0 1-8 4 8 0 Event
Jagged Pill Ltd. T = 39% r = 13% d = 20% Present Value @ 13% $(525,000) 482,996 (64,398) 11,285
Expected Cash Flow
Aftertax Cash Flow 100,650
Purchase machine $(525,000) Cash flow 165,000 Capital upgrade (105,000) Salvage 30,000 CCA pool (PV of tax savings)
0.20 0.39 1 + .5 .13 = [$525,000 + $64,398 $11,285] 0.13 + 0.20 1 + .13 = [$578,113](0.2363636)(0.9424779) = 128,785 NPV = $ 33,668
Note: The $60,000 deposit is a sunk cost and is irrelevant for this decision.
b. Year 0 1-8 4 8 0
Event
Expected Cash Flow
Aftertax Cash Flow
Present Value @ 15%
Purchase machine $(525,000) $(525,000) Cash flow 165,000 100,650 451,649 Capital upgrade (105,000) (60,034) Salvage 30,000 9,807 CCA pool (PV of tax savings) 0.20 0.39 1 + .5 .15 = [$525,000 + $60,034 $9,807] 0.15 + 0.20 1 + .15 = [$575,227](0.22285714)(0.9347826) = 119,833 NPV = ($3,745)
S-400
$33,668 (3,745) $37,413
PV @ 13% PV @ 15%
$33,668 0,000 $33,668
PV @ 13% (Cost)
$33,668 (0.02) = 0.13 + 0.8999(0.02) $37,413 = 0.13 + .0180 = 0.1480 = 14.80% This is an approximation.
c. Profitability index(PI ) = This is calculated @13%.
d. Jagged Pill should purchase the new machine. Value will increase by $33,668 (the NPV), the IRR exceeds the cost of capital and the PI exceeds 1.
S-401
12-42. n = 12 a. Year Event
Galaxydoughs Tea Ltd. T = 39% r = 14% d = 30% Present Value @ 14% ($1,000,000)
Expected Cash Flow
Aftertax Cash Flow
0 Capital expenditure($1,000,000) 0 Previously purchased equipment (opportunity cost of forgoing sale) (300,000) 0 Working capital ( 50,000) 1-6 Cash flow 355,000 216,550 7-12 Cash flow 425,000 259,250 1,008,137 1-12 Rent forgone (70,000) 42,700 (opportunity cost) 12 Salvage 55,000 12 WC Recovery 50,000 0 CCA pool PV (CCA)
(300,000) ( 50,000) 842,091 459,294 (241,694) 11,416 10,378
0.30 0.39 1 + .5 .14 = [$1,000,000 + $300,000 $11,416] 0.14 + 0.30 1 + .14 = [$1,288,584](0.2659091)(0.9385965) = 321,607 NPV = $ 53,092
Galaxydoughs Teas should proceed. Value will be added to the firm. b. A changing cost of capital can be handled by discounting with multiple discount rates appropriate to each year.
S-402
12-43. n=7 Year 0 0 1-7 7 7 8 Event
Rinkydink Roller Rinks Ltd. T = 44% r = 20% d = 20% Present Value @ 20% $(375,000) (65,000) 121,114 251,173 18,140
Expected Cash Flow
Purchase land $(375,000) Working capital (65,000) Cash flow 60,000 Sell land 900,000 WC recovery 65,000 Tax on taxable capital gain [900,000 375,000] 0.50 .44 = $115,500
(26,861) NPV = $ (76,434)
Note:The tax is paid one year after the realization of the capital gain (year 8). This assumption is consistent with other treatments for analysis purposes. Rinkydink should not purchase the vacant lot. Its purchase will decrease the value of the firm by $76,434. If the tax on the capital gain is taken at year 7 its PV is negative $32,234 and the overall present value is a negative $81,807.
S-403
12-44. n = 15 Year 0 0 Event
Clueless Company T = 40% r = 12% (1 .50) = 18% Aftertax Cash Flow d = 30% Present Value @ 18% $(375,000) (32,877) 610,989 (259,670) 1,253 2,746
Expected Cash Flow
Investment $(375,000) Working capital 200,000 60/ 365 = (32,877) 1-15 Revenues 200,000 120,000 1-15 Expenses (85,000) (51,000) 15 Salvage 15,000 15 WC Recovery 32,877 0 CCA pool PV (CCA)
0.30 0.40 1 + .5 .18 = [$375,000 $1,253] 0.18 + 0.30 1 + .18 = [$373,747](0.250)(0.9237288)
= 86,310 NPV =$ 33,751
Clueless should proceed. Value will be added to the firm. This analysis has used an adjusted discount rate to account for the higher risk that would be assumed if the project were undertaken.
S-404
12-45. n = 10 a. Year 0 0 1-10 1-10 1-10 5 10 10 0 Event
Quixotic Enterprises T = 39% r = 20% d = 5% Present Value @ 20% $(400,000) (10,000) 447,546 (19,181) (12,787) (40,188) 4,038 1,615
Expected Cash Flow
Aftertax Cash Flow 106,750 (4,575) (3,050)
Construct windmills$(400,000) Working capital (10,000) Revenues 175,000 Big wind tax (7,500) Rent forgone (opportunity cost) (5,000) Capital upgrade (100,000) Salvage 25,000 WC Recovery 10,000 CCA pool PV (CCA)
0.05 0.39 1 + .5 .20 = [$400,000 + $40,188 $4,038] 0.20 + 0.05 1 + .20 = [$436,150](0.078)(0.9166667 ) = 31,185 NPV = $ 2,228
S-405
b. IRR Year Event 0 0 1-10 1-10 1-10
Expected Cash Flow
Aftertax Cash Flow 106,750 (4,575) (3,050)
Present Value @ 21% $(400,000) (10,000) 432,773 (18,547) (12,365) (38,554) 3,716 1,486
Construct windmills$(400,000) Working capital (10,000) Revenues 175,000 Big wind tax (7,500) Rent forgone (opportunity cost) (5,000) 5 Capital upgrade (100,000) 10 Salvage 25,000 10 WC Recovery 10,000 0 CCA pool PV (CCA)
0.05 0.39 1 + .5 .21 = [$400,000 + $38,554 $3,716] 0.21 + 0.05 1 + .21 = [$436,150](0.075)(0.9132231) = 29,783 NPV = ($11,708
$2,228 (11,708) $13,936 PV @ 20% PV @ 21% $2,228 0,000 $2,228 PV @ 20% (Cost)
$2,228 (0.01) = 0.20 + 0.1599(0.01) $13,936 = 0.20 + .0016 = 0.2016 = 20.16%

c. Profitability index(PI ) =
Just above 1 indicating profitability. (Info from part (a))
d. Dream the impossible dream as it will add value to Quixotic Enterprises.
S-406
12-46. n = 10 Year 0 0 0 1-10 Event
Blue Sky Ltd. T = 40% r = 15% d = 30% Present Value @ 15% $(150,000) 27,500 5,000 90,338 5,932 (1,236)
Expected Cash Flow
Purchase machine $(150,000) Sell old machine 27,500 Deinvest WC 5,000 Incremental annual(50,000 20,000) cost savings 30,000 10 Incremental salvage(32,000 8,000) 24,000 10 Reinvest WC (5,000) 0 CCA pool PV (CCA)
0.30 0.40 1 + .5 .15 = [$150,000 $27,500 $5,932] 0.15 + 0.30 1 + .15 = [$116,568](0.266667 )(0.9347826) = 29,058 NPV = $ 6,592
Blue Sky Ltd. should proceed. Value will be added to the firm. Watch the complete differences between what essentially are two options.
S-407
12-47. n = 10
Midnight Oil and Gas T = 42% r = 14% d (pipeline) = 20% d (buildings) = 4% Present Value @ 14%
Year
Event
Expected Cash Flow
Aftertax Cash Flow
0 Construct pipeline$(1,000,000) $(1,000,000) 0 Construct buildings (200,000) (200,000) 0 Use land (opportunity cost) (2,000,000) (2,000,000) 1-10 Cash flow 625,000 362,500 1,890,842 10 Enviro: cleanup (1,200,000) (696,000) (187,742) 10 Salvage 0 0 10 Sell land 4,500,000 1,213,847 11 Tax on capital gain (4,500,000 500,000) .50 .42 (840,000) (198,759) 1 Tax on capital gain forgone (2,000,000 500,000) .50 .42 315,000 276,316 0 CCA pool (building ) = [$200,000] 0.04 0.42 1 + .5 .14 0.14 + 0.04 1 + .14 = [$200,000](0.0933333)(0.93859649) = 17,520
( pipeline) = [$1,000,000] 0.20 0.42 1 + .5 .14
0.14 + 0.20 1 + .14 = [$1,000,000](0.2470588)(0.93859649) = 231,889 NPV = $ 43,913

Build the pipeline. Value will be added to the firm.
S-408
12-48. n = 12
St. Bernard Venture T = 40% r = 15% d (machinery) d (buildings) = 30% = 4%
Year 0 1 2 3-12 3-12 12 12 12
Event
Expected Cash Flow
Aftertax Cash Flow
Present Value @ 15%
Acquire land $(600,000) $(600,000) Payment building (1,100,000) (956,522) Purchase machinery (175,000) (132,325) Revenues 5875,000 525,000 1,992,328 Expenses (325,000) (195,000) (740,007) Sell building 225,000 42,054 Sell machinery 50,000 9,345 12 Sell land 600,000 (1.09) 1,687,599 315,424 13 Tax on capital gain (1,687,599 600,000) .50 .40 (217,520) (35,353) 0 CCA pool (building ) = [$956,522 $42,054] 0.04 0.40 1 + .5 .15 0.15 + 0.04 1 + .15 = [$914,468](0.0842105)(0.9347826) = 71,986
(machinery ) = [$132,325 $9,345] 0.30 0.40 1 + .5 .15
0.15 + 0.30 1 + .15 = [$122,980](0.2666667 )(0.9347826) = 30,656

NPV = $(2,414) St. Bernard should not proceed with the venture. Value will not be added to the firm.
S-409
12-49. n=9 Year 0 0 3 3 6 6 1-2 3-5 6-9 9 9 0 Event
Marceline Enterprises T = 40% r = 11% d = 15% Present Value @ 11% $(1,000,000) (50,000) (146,238) (7,312) (106,928) (5,346) 256,879 386,758 414,259 58,639 27,365
Expected Cash Flow
Aftertax Cash Flow 150,000 195,000 225,000
[1,000,000 + 146,238 + 106,928 58,639] (.15)(.40) 1 + .5(.11) =
Expansion $(1,000,000) Working capital (50,000) Additional capital (200,000) Additional WC (10,000) Additional capital (200,000) Additional WC (10,000) Revenues 250,000 Revenues 325,000 Revenues 375,000 Salvage 150,000 WC Recovery 70,000 CCA pool
1,194,527 (.2307692) (.9504505)
.11 + .15 1 + .11 262,001 NPV = $90,077
Marceline Enterprises should proceed with the amusement park expansion, as the NPV is positive.
S-410
MINI CASES Aerocomp Corporation (Methods of Investment Evaluation)

This case places emphasis on comparing the payback method, the internal rate of return, and the net present value approaches for a series of investments. As the student progresses through the calculations, the various advantages and disadvantages of the different approaches become evident. The reinvestment assumption of a high return project under the internal rate of return can be highlighted and evaluated. Capital rationing is also introduced into the case and plays a part in the analysis. Finally, the issue of reported earnings to shareholders versus sophisticated capital budgeting techniques is brought up and makes for interesting classroom discussion. Are shareholders more concerned with next quarters earnings or long-term benefits?
a. Total Reported Earnings increases for each projects:

Project A Year 1: Year 2: Year 3: Year 4: Year 5: Total: $(13,250) $ (450) $ 25,494 $101,003 $ 63,315 $176,112 Project B $ 29,313 $ 87,938 $146,563 $234,500 $322,438 $820,752 Project C Project D
$(60,000) $ 192,206 $(16,000) $ 129,846 $ 61,640 $ (43,350) $162,140 $ (62,475) $262,640 $ (94,350) $410,420 $ 121,877
We are told in the case that Kay Marsh is sensitive to Aerocomps level of earnings. Therefore, Project B, with over $820,000 in reported earnings increases (twice as much as any of the other projects), will be the one that attracts Kays attention. (She may initially be swayed by the $192,206 that Project D brings in during the first year, but the losses in years three through five will probably cause her to reject that alternative quickly.) Note: Projects A and C both produce earnings decreases for the first two years. We would suspect that if Emily thinks that either of these two should
S-411
be selected (on the basis of some other ranking method, such as NPV), she had better have some convincing arguments prepared!
S-412
b. Payback Period, IRR, and NPV of each alternative:

Project A Payback Period: IRR: NPV @ 10%: 4 years 14.08% $39,971 Project B 5 Years 7.18% ($63,848) Project C 5 Years 11.95% $52,192 Project D 2 Years 12.48% $20,609
(Students may get slightly different values due to rounding.) Note: A few students may question the fact that Project Bs cost has not been completely recovered in the five-year period shown, as the cost of the other projects has been. Therefore, they will claim, we are not using the proper time frame for our comparison of the projects. Of course, they are correct, and deserve extra points for their astute observation. In the case, Project Bs amortization, or depreciation, was limited on purpose to highlight the effect of amortization on reported income and cash flows.
c. 1. According to the Payback period, Project D should be selected. The

initial investment of $510,000 is recovered in the second year.
2. The chief disadvantage of the Payback Period is obvious at once: the

method ignores cash flows occurring after the payback period. In this case such an omission is disastrous, since Project Ds reported earnings and cash flows fall off significantly after the payback period and never recover. Another disadvantage of the Payback Period is that it does not consider the timing of cash flows during the payback period.
3. In general, the Payback Period should not be used. However, it is used

from time to time because it is easy to understand, and because it favors projects that pay off quickly. This can be an important factor in some fast-paced industries where a quick return is important. The Payback Period may have some justification as a backup method, but not as the primary analytical tool.
S-413
d. 1. According to the IRR method, Project A should be chosen. It returns

nearly two percent more than the closest competing project.
2. Remember, that to achieve the IRR during a projects life, the

projects cash inflows must be reinvested at the IRR rate. This may be difficult or impossible to accomplish when high IRRs are involved. (Suppose you were Aerocomps financial manager, and you were getting the cash flows from Project A. What would you do with them: Pay dividends? Put them in a money market account at? You might encounter a great deal of difficulty locating an investment that would pay you back the IRR rate of 14.08%). As a matter of interest (no pun intended) if Project As cash flows were reinvested at 7% annually instead of the IRR rate of 14.08%, the projects total return for the five-year period would drop to 11.84%.
3. Another disadvantage of the IRR method is that it does not give any
consideration to project size. For example, the IRR method would select a project that returned $10 on a $1 investment over any of the projects in this case, even though the dollar return to the firm was only $9. This is not a problem when all projects with IRRs over the cost of capital can be selected, but when the projects are mutually exclusive, or when capital rationing is in effect (as it is in this case), the IRR method may lead the firm to make an incorrect choice. (Note: It is important to avoid confusion on this point. The IRR and NPV methods will both accept and reject the same investments, but they will not give them the same ranking. In this case, projects A, C, and D are all acceptable per IRR and NPV. However, the IRR method would choose projects A, D, and C, in that order, while the NPV method would choose C, A, and D.)
4. If the size of Aerocomps capital budget were not limited, the IRR
method would accept projects A, C, and D. Project B, with an IRR of 7.18%, almost 3% less than the cost of capital, would be rejected.
S-414
e. 1. According to the NPV method, Project C, with an NPV of over

$52,000, will be chosen. It will add to the present value of the firm over $12,000 more than the next best project. Of course, under the IRR, Project A will be selected. Actually Project C is only a third place finisher under the IRR method.
2. If the size of Aerocomps capital budget were not limited, the NPV
method would accept projects A, C, and D. Project B, with an NPV of negative $63,848, would be rejected anyway. Note that both the NPV and IRR methods rejected project B. The return is less than the cost of capital.
3. The likely selection is Project C because of its high net present value.
This is partly attributable to the fact that only one project can be selected. Had there not been capital limitations, one might put more emphasis on the IRR or use a profitability index approach. Of course, some instructors might select Project A as being preferable using other criteria, and that is fine. There may be some interesting opportunities for a classroom debate or discussion on these points.
f. 1. Profitability index =
Project A Project B Project C Project D [39,971 + 300,000]/ 300,000 = 1.133 [- 63,848 + 700,000]/ 700,000 = 0.909 [52,192 + 800,000]/ 800,000 = 1.065 [20,609 + 510,000]/ 510,000 = 1.040
2. The profitability index suggests project A with the highest relative

profitability. However, project A adds the most value to the firm. Notice that projects A and D together, at roughly the same initial investment as C, provide a higher combined NPV.
S-415
Galaxy Systems, Inc. (Divisional Cost of Capital)

Purpose: The case combines risk analysis with discount rate considerations. To emphasize how many multidivisional corporations operate, the case actually gets into the topic of divisional hurdle rates. The student is able to see how different divisions in a corporation might have different required rates of return based on their risk exposure. In this particular case, a key risk measure for the consideration is beta. (Only observe how they might be used). Calculations related to net present value and internal rate of return are purposely simple to emphasize more conceptual items. (IRRs can be found as exact values from Appendix D after only one calculation, if tables are preferred). Emphasis can be made on how financial decisions are made in a corporate culture. This case draws on material from many of the capital budgeting chapters. Proposal A NPV (10% discount rate for the auto airbags production division) Cost $2,355,600
PV =2,355,600 FV = 0 n = 10 %i = ? %i = 11.00
PMT = $400,000
IRR =
Investment $2,355,600 = = 5.889 (App. D) Annuity $400,000 IRR = 11%

PVA = A PVIFA (n = 10, %i = 10) (Appendix D) PVA = $400,000 6.145 = $2,258,000
n = 10
PV =? FV = 0 PMT = $400,000 n = 10 %i = 10% PV = $2,457,827

$2,457,827 2,355,600 $ 102,227
Present value of inflows Cost Net present value
S-416
Proposal B NPV (15% discount rate for the aerospace division) Cost $2,441,700
PV =2,441,700 FV = 0 n = 10 %i = ? %i = 13.00
PMT = $450,000
IRR =
$2,441,700 = 5.426 (App. D) $450,000 IRR = 13%
n = 10
PMT = $450,000, n = 10, %i = 15 Present value of inflows = $450,000 5.019 = $2,258,550
PV =? FV = 0 PMT = $450,000 n = 10 %i = 15% PV = $2,258,446

$2,258,446 2,441,700 ($ 183,254)
Present value of inflows Cost Net present value Proposal C
NPV (10% discount rate for the auto airbags production division) Cost $145,680
PV =145,680 FV = 0 n = 15 %i = ? %i = 6.00
PMT = $15,000
IRR =
$145,680 = 9.712(App. D) $ 15,000 IRR = 6%
n = 15
S-417
PMT = $15,000, n = 15, %i = 10 Present value of inflows = $15,000 7.606 = $114,090
PV =? FV = 0 PMT = $450,000 n = 15 %i = 10% PV = $114,091

$ 114,091 145,680 ($ 31,589)
Present value of inflows Cost Net present value Proposal D NPV (15% discount rate for the aerospace division) Cost $1,262,100
PV =1,262,100 FV = 0 n=8 %i = ? %i = 17.00
PMT = $300,000
IRR =
$1,262,100 = 4.207( App.D) $300,000 IRR = 17%
n=8
PMT = $300,000, n = 8, %i = 15 Present value of inflows = $300,000 4.487 = $1,346,100
PV =? FV = 0 PMT = $300,000 n=8 %i = 15% PV = $1,346,196

$1,346,196 1,262,100 $ 84,096
Present value of inflows Cost Net present value
S-418
a. Proposal A should be accepted IRR > discount rate (11% > 10%) NPV is positive $102,227 Proposal B should be rejected IRR < discount rate (13% < 15%) NPV is negative ($183,254) Proposal C should be rejected IRR < discount rate (6% < 10%) NPV is negative ($31,589) Proposal D should be accepted IRR > discount rate (17% > 15%) NPV is positive $84,096 b. While the decisions related to Proposals A and B appear to be straightforward, Proposals C and D require further discussion. Proposal C has a negative net present value and the internal rate of return of 6% is well below the required rate of return of 10%. Nevertheless, it calls for the development of special equipment to be used in the disposal of environmentally harmful waste material created in the manufacturing process. Given tougher environmental laws, the project may have to be accepted. We are not told whether the installation is mandatory under the law, but there probably is adequate motivation to move forward with the project. Of course, if the installment of the equipment is required by law, then Galaxy must move forward regardless of the numbers. Proposal D has a positive net present value and the internal rate of return of 17 percent is well above the required rate of return of 15 percent for the division. However, the proposal appears to have even greater risk than projects normally undertaken in the aerospace division. While the high required rate of return for this division is supposed to cover the risk exposure of dealing in U.S. government contracts, Project D calls for the development of a microelectric control system for fighter jets that are still in the design stage. Even if the microelectric systems are successfully developed, there may not be a need for them if the other aerospace company cannot successfully develop fighter jets. Furthermore, the target market for the jets is in underdeveloped countries, which increases the uncertainty associated with this project. In the final analysis, top management might require an anticipated return of 20 percent or more to take on this highly speculative project.
S-419
c. The $300,000 that has already been spent on the initial research for Proposal B (radar surveillance equipment) is a sunk cost. The money has already been spent and should have no influence on subsequent decisions. Sometimes in the real world, egos get in the way of corporate decisions, and division heads (or other executives) push hard for the continuance of projects that they spent funds on to explore; but that is not justification to continue on. This is somewhat like buying stock in an underperforming company in the stock market. Sometimes, you just have to take your losses. Of course, even if we considered the $300,000 that had already been spent, it would raise the total cost of the project and make it even less economical. Further overall comments: Companies that use divisional required rates of return often do have difficulties in finding betas for firms that produce products comparable to a division. That is, finding a pure play comparison is difficult. Therefore, using the average beta for an entire industry may be the next best alternative. For example, if a division produces machine tools, its beta may be inferred from the entire machine tool industry rather than from a given firm in the industry.
S-420

Practice Problems Ch12

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Practice Problems Ch12

Uploaded by

Copyright:

Available Formats

Practice Problems Chapter 12 Problems 12-1.

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Blink 281 Corporation a. Average accounting return ( AAR ) =

Average earnings aftertax Average book value

Year EBAT 1 $35,000 2 37,000 3 41,000 4 45,000 5 50,000

Amortization $16,000 16,000 16,000 16,000 16,000

EBT $19,000 21,000 25,000 29,000 34,000

Average earnings aftertax

Average accounting return ( AAR ) =

$15,360 = 0.3840 = 38.4% $80,000 / 2

Average earnings aftertax

Average accounting return ( AAR ) =

$34,000 = 0.3238 = 32.38% $210,000 / 2

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Average earnings aftertax

Average accounting return (AAR ) =

$34,000 = 0.3238 = 32.38% ($210,000 + 0) / 2

8/E Cdn. Block, Hirt, Short

Neither project is attractive, with investment Y less attractive.

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Present value @ 10% $5,455 3,306 2,254 $11,015 10,000 $ 1,015

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Present value @ 10% $4,545 2,479 6,011 $13,035 10,000 $ 3,035

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Warner Business Products

8/E Cdn. Block, Hirt, Short

Present value @ 12% $17,857 14,349 9,253 $41,459 40,000 $ 1,459

The machine should be purchased as the NPV is positive. c. Profitability index =

PV of inflows $41,459 = = 1.04 PV of outflows $40,000

The NPV is positive and the project should be undertaken.

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

12-19. a. NPV Year 1 2 3 4 5

Present value @ 11% $ 4,505 4,058 5,850 5,929 5,935 $26,277

Present value @13% $ 4,425 3,916 5,544 5,520 5,428 $24,833

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

IRR (interpolate ) = 0.11 +

$1,277 (0.02) = 0.11 + 0.884(0.02) $1,444 = 0.11 + .0177 = 0.1277 = 12.77%

Calculator: 10,000 Compute:

n=5 %i =? IRR = 12.76%

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Adventures Club, Inc.

PV of inflows $12,834 = = 1.2834 PV of outflows $10,000

PV of inflows $26,016 = = 1.1825 PV of outflows $22,000

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Foundations of Fin. Mgt.

8/E Cdn. Block, Hirt, Short

Last Century Corporation

Inflows $12,000 10,000 7,200

# of Periods 2 1 0 Terminal value

Future value $13,739 10,700 7,200 $31,639

PV $25,000 = = 0.790 (Appendix B) FV $31,639

At 3 periods, appendix B suggests a modified IRR of 8%