CHAPTER 22

DISCUSSION QUESTIONS

Q22-1. Effective planning and control of capital expenditures are important because: (a) financial risk is increased by long-term commitments; (b) the magnitude of capital expenditures is substantial and the penalties for unwise decisions are usually severe; (c) decisions made in this area provide the supporting structure for operating activities of the firm. Q22-2. Examples of opportunities and temptations for unethical behavior in the capital budgeting area include: (a) pressure applied to the cost/managerial accountant by superiors or associates to circumvent the capital expenditure approval process, in order to get a pet project approved; (b) pressure to write off or devalue assets below their true value in order to justify replacement; (c) exaggerating the expected economic benefits of a pet project in order to increase the likelihood of getting it approved Q22-3. The cost/managerial accountant has an obligation to the company to make sure that the companys legitimate policies and procedures are not circumvented and to make sure that the data used in the evaluation of capital expenditure proposals are as reliable and realistic as possible. If an ethical violation occurs, the cost/managerial accountant should first discuss the perceived problem with his or her immediate supervisor (in order to clarify the significance of the problem and identify possible courses of action) and then with the individual or individuals involved. If the individual involved is the accountants immediate supervisor, the cost/managerial accountant should consult the next higher level of management. If the problem cannot be resolved through discussion, the cost/managerial accountant is obligated to provide a full disclosure of all the details to the executives responsible for evaluating and approving capital expenditures.

Q22-4. The economic life of a project is the period during which it produces earnings. It need not, and probably will not, be equal to the physical life of the related asset(s). Its length depends primarily upon the obsolescence of the product or manufacturing process involved or the nature of the product itself. Managers usually find it quite difficult to estimate economic life because it depends upon future events over which they may have little or no control. Q22-5. Cash outflows that might be expected for a capital expenditure include: (a) purchase price of one or more assets (or a down payment if property is purchased on installment); (b) construction period interest and taxes if the property is being constructed; (c) machinery and equipment setup cost, particularly if machinery being evaluated utilizes a more advanced technology than that currently in use; (d) computer software development cost if a computer aided design, computer aided manufacturing, or fully computer integrated manufacturing system is being purchased; (e) increased annual maintenance and/or power costs resulting from more complicated or technologically advanced machinery or equipment; (f) lease payments, if some or all of the assets being acquired in the project are leased; (g) working capital requirements (inventory, cash on hand, receivables, payables, etc.) may increase as a result of increased business generated by the capital project. Q22-6. Cash inflows that might be expected from a capital expenditure include: (a) revenues from additional business generated by the project; (b) cost savings created by the capital expenditure that result in a reduction of cash outflows (e.g., maintenance savings,

22-1

22-2

Chapter 22

labor savings, reduced inventory requirements resulting from reduced setup times, etc.); (c) retention of market share that might have been lost if the capital expenditure were not made (particularly in the case of advanced technologies that improve product quality, reduce costs, provide manufacturing flexibility, etc. that can provide a competitive advantage to the firm with the technology); (d) salvage from the sale of the property at the end of the economic life of the capital project. Q22-7. Some nonquantifiable benefits from investing in advanced manufacturing technologies, such as CIM, FMS, and robotics, include: (a) improved product quality (ability to meet closer production tolerances and at the same time reduce the variability in production output); (b) decreased machine setup and shorter manufacturing cycle times (which provide the company with the ability to adjust output quantity and variety quickly to meet rapidly changing customer demands). Q22-8. Tax depreciation is quite likely to differ from book depreciation because the cost recovery period used for tax purposes is usually shorter than the economic life of the asset used for financial accounting purposes. Also, an accelerated method of depreciation is typically used for tax purposes, whereas the straight-line method is more often used for book purposes. Q22-9. Book depreciation should not be considered in estimating the future cash flows from a project because book depreciation has no effect on the amount or timing of cash flows. Q22-10. Tax depreciation should be considered in estimating the future cash flows from a project because tax depreciation reduces taxable income and, therefore, tax liability. Tax depreciation results in a tax savings, i.e., a reduction

of tax liability that is a cash outflow. The timing of cash flows is affected by the tax depreciation method and the recovery period used. Q22-11. Financial accounting data are not entirely suitable for use in evaluating capital expenditure proposals because: (a) Financial accounting uses the accrual basis. Capital expenditure decisions generally rely on estimates of cash flows, rather than revenues and expenses determined on the accrual basis. (b) Financial accounting is designed to measure periodic earnings. Capital expenditure evaluation is concerned with the life of a given project, which seldom corresponds to usual accounting periods. (c) Financial accounting measures the results of operations of a company or a segment of a company. Although this entity sometimes corresponds with a capital expenditure project, it is usually composed of many intermingled capital expenditure projects. (d) Financial accounting capitalizes expenditures if the expenditure is deemed to have a future value or benefit to the company. Capitalization is an attempt to match expenditures with revenues generated by those expenditures. When future value or benefit cannot be reliably measured, financial accounting treats the expenditure as a period expense rather than as an asset acquisition. Q22-12. Benefits of following up project results include: (a) comparison of actual with projected results to ensure that a project is meeting expected performance, or taking corrective action or terminating a project that is not achieving expected performance; (b) evaluation of accuracy of projections from different departments; (c) improvement of future capital estimates; (d) motivation of personnel arising from knowledge that follow-up will occur.

Chapter 22

22-3

EXERCISES E22-1 Estimated Unit Unit Unit Demand Sales Variable Contribution Year in Units Price Cost Margin 1 12,000 $25 $15 $10 2 12,000 25 15 10 3 12,000 25 15 10 4 12,000 25 15 10 5 12,000 25 15 10 Total net pretax cash inflows from sales ....................................... Initial cash outflow (cost of asset) .............................. $500,000 Less pretax estimated salvage value ........................... (100,000) Excess of net pretax cash inflows over cost ................................ E22-2 Estimated Unit Unit Unit Demand Sales Variable Contribution Year in Units Price Cost Margin 1 6,000 $12 $9 $3 2 8,000 12 9 3 3 10,000 12 9 3 4 10,000 12 9 3 5 10,000 12 9 3 6 10,000 12 9 3 7 10,000 12 9 3 8 8,000 12 9 3 9 6,000 12 9 3 10 4,000 12 9 3 Total net pretax cash inflows from sales ....................................... Initial cash outflow (cost of machine) .......................... $150,000 Less pretax estimated salvage value ........................... (20,000) Excess of net pretax cash inflows over cost ................................ Net Pretax Cash Inflows From Sales $ 18,000 24,000 30,000 30,000 30,000 30,000 30,000 24,000 18,000 12,000 $246,000 130,000 $116,000 Net Pretax Cash Inflows From Sales $120,000 120,000 120,000 120,000 120,000 $600,000 400,000 $200,000

22-4

Chapter 22

E22-3 Estimated 6% Annual Net Pretax Price-level Year Cash Inflows Adjustment 1 $15,000 (1 + .06)1 = 1.060 2 20,000 (1 + .06)2 = 1.124 3 20,000 (1 + .06)3 = 1.191 4 20,000 (1 + .06)4 = 1.262 5 15,000 (1 + .06)5 = 1.338 6 10,000 (1 + .06)6 = 1.419 Total price-level adjusted net pretax cash inflows from operations ........................................... Plus cash inflow from salvage ........................... $5,000 Price-level adjustment ........................................ 1,419 Total price-level adjusted net pretax cash inflows ............................................ Less initial cash outflow ................................................... Excess of net pretax cash inflows over initial cash outflow.................................................... E22-4 Estimated 9% Annual Net Pretax Price-level Year Cash Inflows Adjustment 1 $20,000 (1 + .09)1 = 1.090 2 30,000 (1 + .09)2 = 1.188 3 40,000 (1 + .09)3 = 1.295 4 60,000 (1 + .09)4 = 1.412 5 60,000 (1 + .09)5 = 1.539 6 60,000 (1 + .09)6 = 1.677 7 60,000 (1 + .09)7 = 1.828 8 60,000 (1 + .09)8 = 1.993 9 40,000 (1 + .09)9 = 2.172 10 20,000 (1 + .09)10 = 2.367 Total price-level adjusted net pretax cash inflows from operations............................................... Plus cash inflow from salvage ........................... $10,000 Price-level adjustment ........................................ 2.357 Total price-level adjusted net pretax cash inflows ............................................... Less initial cash outflow....................................................... Excess of net pretax cash inflows over initial cash outflow ...................................................... Price-level Adjusted Net Cash Inflows $ 21,800 35,640 51,800 84,720 92,340 100,620 109,680 119,580 86,880 47,340 $750,400 23,670 $774,070 250,000 $524,070 Price-level Adjusted Net Cash Inflows $15,900 22,480 23,820 25,240 20,070 14,190 $121,700 7,095 $128,795 75,000 $53,795

Chapter 22

E22-5 (6) Net After-tax Cash Inflows (1) (2) (5) $168,000 196,800 166,080 147,600 147,600 133,920 $960,000 600,000 $360,000

(1) (2) (3) (4) (5) Annual Additional Tax Liability Operating Maintenance Tax Taxable With 40% Savings Cost DepreIncome Tax Rate Year With CIM* With CIM ciation** (1) (2) (3) 40% (4) 1 $400,000 $200,000 $120,000 $ 80,000 $32,000 2 400,000 200,000 192,000 8,000 3,200 3 400,000 200,000 115,200 84,800 33,920 4 400,000 200,000 69,000 131,000 52,400 5 400,000 200,000 69,000 131,000 52,400 6 400,000 200,000 34,800 165,200 66,080 Total net after-tax cash inflows .................................................................................................. Less initial cash outflow to purchase system.......................................................................... Excess of net after-tax cash inflows over initial cash outflow ............................................... 20,000 $20 $400,000

*Annual hours of operating capacity Savings per hour with CIM

** Depreciable Basis $600,000 600,000 600,000 600,000 600,000 600,000 Tax Depreciation $120,000 192,000 115,200 69,000 69,000 34,800 $600,000

Year 1 2 3 4 5 6

MACRS 5-year Recovery Rate .200 .320 .192 .115 .115 .058 1.000

22-5

22-6

Chapter 22

E22-6 (1) (2) (3) (4) Estimated Taxable Tax Liability InflationTax Income With 40% Adjusted Net Depre(Loss) Tax Rate Year Cash Inflows ciation* (1) (2) 40% (3) 1 $30,000 $40,000 $(10,000) $(4,000) 2 40,000 64,000 (24,000) (9,600) 3 50,000 38,400 11,600 4,640 4 60,000 23,000 37,000 14,800 5 70,000 23,000 47,000 18,800 6 80,000 11,600 68,400 27,360 7 60,000 0 60,000 24,000 Total net after-tax cash inflows........................................................ Less initial cash outflow to purchase system ............................... Excess of net after-tax cash inflows over initial cash outflow ..... * Year 1 2 3 4 5 6 MACRS 5-year Recovery Rate .200 .320 .192 .115 .115 .058 1.000 Depreciable Basis $200,000 200,000 200,000 200,000 200,000 200,000 (5) Net After-tax Cash Inflows (1) (4) $ 34,000 49,600 45,360 45,200 51,200 52,640 36,000 $314,000 200,000 $114,000 Tax Depreciation $ 40,000 64,000 38,400 23,000 23,000 11,600 $200,000

Chapter 22

22-7

E22-7 (1) (2) (3) (4) (5) Estimated Taxable Tax Liability Net Periodic Tax Income With 40% After-tax Net Cash Depre(Loss) Tax Rate Cash Inflows Year Inflows ciation* (1) (2) 40% (3) (1) (4) 1 $10,000 $14,300 $(4,300) $(1,720) $ 11,720 2 15,000 24,500 (9,500) (3,800) 18,800 3 20,000 17,500 2,500 1,000 19,000 4 25,000 12,500 12,500 5,000 20,000 5 25,000 8,900 16,100 6,440 18,560 6 25,000 8,900 16,100 6,440 18,560 7 25,000 8,900 16,100 6,440 18,560 8 20,000 4,500 15,500 6,200 13,800 9 15,000 0 15,000 6,000 9,000 10 10,000 0 10,000 4,000 6,000 Total net after-tax cash inflows ................................................................ $154,000 After-tax cash inflow from salvage at end of economic life: Pretax cash inflow from salvage................................. $10,000 Less tax payable on sale at 40% tax rate................... 4,000 6,000 Total net after-tax cash inflows ................................................................ $160,000 Less initial cash outflow to purchase system ......................................... 100,000 Excess of net after-tax cash inflows over initial cash outflow .............. $ 60,000 * Year 1 2 3 4 5 6 7 8 MACRS 7-year Recovery Rate .143 .245 .175 .125 .089 .089 .089 .045 1.000 Depreciable Basis $100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 Tax Depreciation $ 14,300 24,500 17,500 12,500 8,900 8,900 8,900 4,500 $100,000

22-8

Chapter 22

Problems
P22-1 (1) (2) (3) InflationAdjusted Estimated Cash Inflows (1) (2) $ 20,520 25,652 30,240 24,480 22,035 15,870 $138,797 (3) Tax Depreciation (1) (2) $12,000 19,200 11,520 6,900 6,900 3,480 $60,000

Year 1 2 3 4 5 6

Periodic Cash Inflows $19,000 22,000 24,000 18,000 15,000 10,000 $109,000 (1) Depreciable Basis of Property $60,000 60,000 60,000 60,000 60,000 60,000

8% Price-Level Adjustment (1 + .08) = 1.080 (1 + .08)2 = 1.166 (1 + .08)3 = 1.260 (1 + .08)4 = 1.360 (1 + .08)5 = 1.469 (1 + .08)6 = 1.587

Year 1 2 3 4 5 6

(2) 5-Year Property Recovery Percentage .200 .320 .192 .115 .115 .058

Chapter 22

P22-1 (Concluded)

(4) (5) Federal Adjusted Taxable and Estimate of Tax Income State Income Net Cash Depre(Loss) Income Tax Year Inflows ciation (1) (2) Tax Rate (3) (4) 1 $20,520 $12,000 $ 8,520 40% $3,408 2 25,652 19,200 6,452 40% 2,581 3 30,240 11,520 18,720 40% 7,488 4 24,480 6,900 17,580 40% 7,032 5 22,035 6,900 15,135 40% 6,064 6 15,870 3,480 12,390 40% 4,956 Total estimated net after-tax cash inflows from project .......................................................... Less initial cash outlay for machinery ...................................................................................... Excess of after-tax cash inflows from project over Initial cash outflow ...............................

(1)

(2)

(3)

(6) Net After-tax Cash Inflows (1) (5) $ 17,112 23,071 22,752 17,448 15,981 10,914 $107,278 60,000 $ 47,278

22-9

22-10

Chapter 22

P22-2 Cost of new machine ....................................................................................... Trade-in allowance for old machine................................................................ Net cash outflow at beginning of project....................................................... Tax basis of old machine traded in ................................................................ Tax basis of new machine ............................................................................... Annual cost of operating old machine ........................................................... Annual cost of operating new machine ......................................................... Annual cost savings with new machine......................................................... (1) Original Tax Basis of Old Machine $10,000 10,000 10,000 10,000 10,000 (2) (3) Tax Depreciation on Old Machine (1) (2) $3,200 1,920 1,150 1,150 580 $8,000 (3) Tax Depreciation on New Machine (1) (2) $3,400 5,440 3,264 1,955 1,955 986 $17,000 $18,000 9,000 $ 9,000 8,000 $17,000 $20,000 16,400 $ 3,600

Year 1 2 3 4 5

5-Year Property Recovery Rate .320 .192 .115 .115 .058

(1) Original Tax Basis of New Machine $17,000 17,000 17,000 17,000 17,000 17,000

(2)

Year 1 2 3 4 5 6

5-Year Property Recovery Rate .200 .320 .192 .115 .115 .058

Note that year 1 is actually the second year the old property is depreciated. Therefore, the recovery rate for the second year is used to compute the amount of depreciation on the old property in the first year of the capital expenditure proposal.

Chapter 22

P22-2 (Concluded) (2)

(3) (4) (5) (6) (7) (8) Additional Annual Tax Cost Increase Increase Allowable Depreciation Savings (Decrease) (Decrease) Net Tax Depreciation with New With in Taxable Income in Income Cash New Old Machine New Income Tax Tax Inflow Year Machine Machine (1) (2) Machine (4) (3) Rate (5) (6) (4) (7) 1 $3,400 $3,200 $ 200 $3,600 $3,400 40% $1,360 $ 2,240 2 5,440 1,920 3,520 3,600 80 40% 32 3,568 3 3,264 1,150 2,114 3,600 1,486 40% 594 3,006 4 1,955 1,150 805 3,600 2,795 40% 1,118 2,482 5 1,955 580 1,375 3,600 2,225 40% 890 2,710 6 986 0 986 3,600 2,614 40% 1,046 2,554 Total increase in periodic cash inflows .................................................................................................. $16,560 Less initial cash outlay for new machine ............................................................................................... 9,000 Increase in cash inflows over initial cash outlay for new machine ..................................................... $ 7,560

(1)

22-11

22-12

Chapter 22

P22-3 (1) Cost to purchase valve stem from outside supplier ($20 per unit 80,000 units per year) ....................................... Incremental cost of manufacturing valve stem: Direct materials ($4.50 80,000 units) ..................................... Direct labor (($3.70 $.80) per unit 80,000 units) ................ Variable factory overhead (($1.70 $.80) per unit 80,000 units) .......................................................................... Total incremental costs ........................................................ Total annual costs savings to make rather than buy ....................... (1) Tax Basis of New Tools $2,500,000 2,500,000 2,500,000 2,500,000 (2) 3-Year Property Recovery Rate .333 .444 .148 .075 (3) Tax Depreciation on New Tools (1) (2) $ 832,500 1,110,000 370,000 187,500 $2,500,000

$1,600,000 $ 360,000 232,000 72,000 $ 664,000 $ 936,000

Year 1 2 3 4

Chapter 22

P22-3 (Concluded) (2) (6) Net After-tax Cash Inflows (1) (5) $ 894,600 1,005,600 709,600 636,600 561,600 $3,808,000

(3) (4) (5) Increase Increase Tax (Decrease) (Decrease) Depreciation in Taxable Income in Income Cost on New Income Tax Taxes Year Savings Tools (1) (2) Rate (3) (4) 1 $936,000 $ 832,500 $ 103,500 40% $ 41,400 2 936,000 1,110,000 (174,000) 40% (69,600) 3 936,000 370,000 566,000 40% 226,400 4 936,000 187,500 748,500 40% 299,400 5 936,000 0 936,000 40% 374,400 Total periodic cash inflows from annual cost savings ....................................................... After-tax disposal value of specialized tools: Cash inflow from salvage of tools ................................................................. $100,000 Less tax on salvage of tools .......................................................................... 40,000 Total after-tax cash inflows from making product...............................................................

(1)

60,000 $3,868,000 $3,868,000 2,500,000 $1,368,000

(2) Total after-tax cash inflows from making product (from part (1) above) .......................... Initial cash outlay to purchase tools..................................................................................... Excess of total net after-tax cash inflows over initial cost of capital project ..................

22-13

22-14

P22-4 (2) Annual Fixed Lease Rentals $20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 (3) (4) (5) InflationAdjusted Cash Inflows (3) (4) $ 63,600 78,680 95,280 100,960 107,040 113,520 120,320 127,520 101,340 71,640 (6)

(1)

Estimated Estimated Annual Operating Year Revenues Expenses 1 $100,000 $40,000 2 120,000 50,000 3 140,000 60,000 4 140,000 60,000 5 140,000 60,000 6 140,000 60,000 7 140,000 60,000 8 140,000 60,000 9 120,000 60,000 10 100,000 60,000

Unadjusted Cash Inflows (1) (2) $60,000 70,000 80,000 80,000 80,000 80,000 80,000 80,000 60,000 40,000 Annual 6% Inflation Adjustment (1 + .06) = 1.060 (1 + .06)2 = 1.124 (1 + .06)3 = 1.191 (1 + .06)4 = 1.262 (1 + .06)5 = 1.338 (1 + .06)6 = 1.419 (1 + .06)7 = 1.504 (1 + .06)8 = 1.594 (1 + .06)9 = 1.689 (1 + .06)10 = 1.791

(7) Pretax Annual Cash Inflows (5) (6) $ 43,600 58,680 75,280 80,960 87,040 93,520 100,320 107,520 81,340 51,640 $779,900

Year 1 2 3 4 5 6 7 8

(1) Tax Basis for Depreciable Property $200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000

(2) 7-Year Property Recovery Rate .143 .245 .175 .125 .089 .089 .089 .045

(3) Tax Depreciation Available (1) (2) $ 28,600 49,000 35,000 25,000 17,800 17,800 17,800 9,000 $200,000

Chapter 22

Chapter 22

P22-4 (Concluded) (1) (2) (6) After-tax Cash Inflows (1) (5) $ 37,600 54,808 59,168 58,576 59,344 63,232 67,312 68,112 48,804 30,984 $547,940 200,000 $347,940

(3) (4) (5) Increase Increase Pretax (Decrease) (Decrease) Annual Tax in Taxable Income in Income Cash Depreciation Income Tax Taxes Year Inflows Available (1) (2) Rate (3) (4) 1 $ 43,600 $28,600 $15,000 40% $ 6,000 2 58,680 49,000 9,680 40% 3,872 3 75,280 35,000 40,280 40% 16,112 4 80,960 25,000 55,960 40% 22,384 5 87,040 17,800 69,240 40% 27,696 6 93,520 17,800 75,720 40% 30,288 7 100,320 17,800 82,520 40% 33,008 8 107,520 9,000 98,520 40% 39,408 9 81,340 0 81,340 40% 32,536 10 51,640 0 51,640 40% 20,656 Total after-tax cash inflows from proposed investment .......................................................... Less initial investment cash outflow ......................................................................................... Excess of total after-tax cash inflows over initial cash outflow.............................................

22-15

22-16

P22-5

(1) (2) Periodic Net Cash Inflows (5) + (6) $ 7,500 7,200 6,900 6,600 6,300 6,000 6,000 $46,500 (3) (5) Net Cash Inflow From Sales (1) (4) $ 6,000 6,000 6,000 6,000 6,000 6,000 6,000 $42,000 (6) Cost Savings From Reduced Maintenance $1,500 1,200 900 600 300 0 0 $4,500 (7)

(4) Contribution Unit Unit Margin Estimated Sales Variable Per Unit Year Demand Price Cost (2) (3) 1 1,000 $11 $5 $6 2 1,000 11 5 6 3 1,000 11 5 6 4 1,000 11 5 6 5 1,000 11 5 6 6 1,000 11 5 6 7 1,000 11 5 6 Total periodic cash inflows .....................................................

(1)

Chapter 22

Chapter 22

22-17

P22-5 (Continued) (1) (2) (3) Adjusted Estimate of Net Cash Inflows (1) (2) $ 8,250 8,712 9,184 9,662 10,149 10,632 11,694 $68,283

Year 1 2 3 4 5 6 7

Periodic Net Cash Inflows $ 7,500 7,200 6,900 6,600 6,300 6,000 6,000 $46,500 (1) Depreciable Basis of Machine $40,000 40,000 40,000 40,000 40,000 40,000

Annual 10% Price-Level Adjustment (1 + .10) = 1.100 (1 + .10)2 = 1.210 (1 + .10)3 = 1.331 (1 + .10)4 = 1.464 (1 + .10)5 = 1.611 (1 + .10)6 = 1.772 (1 + .10)7 = 1.949

Recovery Year 1 2 3 4 5 6

(2) 5-Year Property Recovery Percentage .200 .320 .192 .115 .115 .058

(3) Tax Depreciation (1) (2) $ 8,000 12,800 7,680 4,600 4,600 2,320 $40,000

22-18

P22-5 (Concluded) (2) (3) (6) Net After-tax Cash Inflows (1) (5) $ 8,150 10,347 8,582 7,637 7,929 7,307 7,016 $56,968

(4) (5) Federal Income Adjusted Taxable and Tax Estimate of Income State Payment Net Cash Tax (Loss) Income (Reduction) Year Inflows Depreciation (1) (2) Tax Rate (3) (4) 1 $ 8,250 $ 8,000 $ 250 40% $ 100 2 8,712 12,800 (4,088) 40% (1,635) 3 9,184 7,680 1,504 40% 602 4 9,662 4,600 5,062 40% 2,025 5 10,149 4,600 5,549 40% 2,220 6 10,632 2,320 8,312 40% 3,325 7 11,694 0 11,694 40% 4,678 Total after-tax cash inflow from sales and cost savings .................................................... After-tax cash inflow from salvage at end of economic life: Cash inflow from salvage (adjusted for expected 10% inflation)* ............. $11,694 Tax payable on salvage sale**........................................................................ 4,678 Total net after-tax cash inflows from the capital expenditure ............................................ 7,016 $63,984

(1)

*$6,000 estimated salvage value 1.949 inflation adjustment (10% for 7 years)

**The cash inflow from the salvage sale at the end of the project would be fully taxable because the tax basis of the machine would be zero (i.e., the machine was fully depreciated). Thus, the tax on the cash inflow from salvage would be $4,678 ($11,694 40%). $63,984 40,000 $23,984
Chapter 22

(2) Total after-tax cash inflows from the capital expenditure .................................................. Less original investment cash outflow................................................................................. Excess of total after-tax cash inflows over initial investment............................................

Chapter 22

22-19

P22-6 (1) (2) (3) InflationAdjusted Cash Inflows (1) (2) $16,500 24,200 33,275 36,600 40,275 44,300 48,725 42,880 35,370 25,940

Year 1 2 3 4 5 6 7 8 9 10

Unadjusted Cash Inflows $15,000 20,000 25,000 25,000 25,000 25,000 25,000 20,000 15,000 10,000 (1) Tax Basis of Depreciable Property $100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

Annual 10% Price-Level Adjustment (1 + .10) = 1.100 (1 + .10)2 = 1.210 (1 + .10)3 = 1.331 (1 + .10)4 = 1.464 (1 + .10)5 = 1.611 (1 + .10)6 = 1.772 (1 + .10)7 = 1.949 (1 + .10)8 = 2.144 (1 + .10)9 = 2.358 (1 + .10)10 = 2.594 (2) 7-Year Property Recovery Rate .143 .245 .175 .125 .089 .089 .089 .045 (3) Tax Depreciation Available (1) (2) $ 14,300 24,500 17,500 12,500 8,900 8,900 8,900 4,500 $100,000

Year 1 2 3 4 5 6 7 8

22-20

P22-6 (Concluded) (6) After-tax Cash Inflows (1) (5) $ 15,620 24,320 26,965 26,960 27,725 30,140 32,795 27,528 21,222 15,564 $248,839

(1) (2) (3) (4) (5) InflationIncrease Increase Adjusted (Decrease) (Decrease) Annual Tax in Taxable Income in Income Cash Depreciation Income Tax Taxes Year Inflows Available (1) (2) Rate (3) (4) 1 $16,500 $14,300 $ 2,200 40% $ 880 2 24,200 24,500 (300) 40% (120) 3 33,275 17,500 15,775 40% 6,310 4 36,600 12,500 24,100 40% 9,640 5 40,275 8,900 31,375 40% 12,550 6 44,300 8,900 35,400 40% 14,160 7 48,725 8,900 39,825 40% 15,930 8 42,880 4,500 38,380 40% 15,352 9 35,370 0 35,370 40% 14,148 10 25,940 0 25,940 40% 10,376 Total periodic after-tax cash inflows ............................................................................................ After-tax cash inflow from salvage: Inflation-adjusted cash inflow from salvage ($2,000 2.594) ........................... $5,188 Tax payable on salvage ($5,188 40%)............................................................... 2,075 Total after-tax cash inflows from project ..................................................................................... Less initial investment cash outflow............................................................................................ Excess of total after-tax cash inflows over initial investment................................................... 3,113 $251,952 100,000 $151,952

Chapter 22

P22-7

Chapter 22

(1)
(3) (7)

(1)

Year

Savings from Reduced Labor Annual 6% Inflation Adjustment

(2) Savings from Reduced Machine Setup Time Savings from Reduced Inventory

(4) Total Periodic Savings from CIM (1) + (2) + (3)

(5) Additional Maintenance Cost with CIM

(6) Net Periodic Savings with CIM (4) (5)

(8) InflationAdjusted Periodic Savings (6) (7)

1 2 3 4 5 6

$15,000 25,000 35,000 35,000 35,000 35,000

$25,000 30,000 35,000 35,000 35,000 35,000

$20,000 25,000 30,000 30,000 30,000 30,000

$ 60,000 80,000 100,000 100,000 100,000 100,000

$10,000 10,000 10,000 10,000 10,000 10,000

$50,000 70,000 90,000 90,000 90,000 90,000

(1 + .06) (1 + .06)2 (1 + .06)3 (1 + .06)4 (1 + .06)5 (1 + .06)6

= = = = = =

1.060 1.124 1.191 1.262 1.338 1.419

$53,000 78,680 107,190 113,580 120,420 127,710 (6) Periodic Net After-tax Cash Inflows (1) (5) $ 127,800 191,208 157,114 130,148 134,252 99,826 $ 840,348

(1) (2) (3) (4) (5) InflationAdjusted Tax Taxable Tax Periodic Depreciation Income Effective Liability Savings and (Loss) Tax (Refund) Year with CIM Amortization* (1) (2) Rate (3) (4) 1 $ 53,000 $240,000 $(187,000) 40% $ (74,800) 2 78,680 360,000 (281,320) 40% (112,528) 3 107,190 232,000 (124,810) 40% (49,924) 4 113,580 155,000 (41,420) 40% (16,568) 5 120,420 155,000 (34,580) 40% (13,832) 6 127,710 58,000 69,710 40% 27,884 Total annual after-tax savings from investment in CIM............................................................... Less initial investment: Equipment cost............................................................................................... $1,000,000 Software cost .................................................................................................. 200,000 Excess of cost of CIM system over after-tax savings .................................................................

1,200,000 $(359,652)

22-21

P22-7 (Continued)
22-22

(1)

(2)

(3)

(4)

(5)

(6))

Year 1 2 3 4 5 6

Recovery Property Tax Basis $1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Software Tax Basis $200,000 200,000 200,000 200,000 200,000 200,000

Rate for MACRS 5-year Property .200 .320 .192 .115 .115 .058 Tax Depreciation (1) (2) $ 200,000 320,000 192,000 115,000 115,000 58,000 $1,000,000

5-year Straight-line Amortization Rate .200 .200 .200 .200 .200 .000

Tax Amortization (4) (5) $ 40,000 40,000 40,000 40,000 40,000 0 $200,000

(7) Total Tax Amortization and Depreciation (3) + (6) $ 240,000 360,000 232,000 155,000 155,000 58,000 $1,200,000

(2)

(1) (2) (3) (4) (5) (6) (7) (8) InflationInflationTax Periodic Adjusted Adjusted Net DepreNet Periodic Lost Periodic Periodic ciation Taxable Tax After-tax Savings Contribution Savings and Income Effective Liability Cash with CIM Margin Saved with CIM Amor(Loss) Tax (Refund) Inflows Year from Part (1) with CIM** (1) + (2) tization* (3) (4) Rate (5) (6) (3) (7) 1 $ 53,000 $212,000 $265,000 $240,000 $ 25,000 40% $ 10,000 $ 255,000 2 78,680 224,800 303,480 360,000 (56,520) 40% (22,608) 326,088 3 107,190 238,200 345,390 232,000 113,390 40% 45,356 300,034 4 113,580 252,400 365,980 155,000 210,980 40% 84,392 281,588 5 120,420 267,600 388,020 155,000 233,020 40% 93,208 294,812 6 127,710 283,800 411,510 58,000 353,510 40% 141,404 270,106 Total annual after-tax savings from investment in CIM...................................................................... $1,727,628 Less initial investment for equipment and software (from above) ................................................... 1,200,000 Excess of after-tax savings over cost of CIM system with new information................................... $ 527,628

Chapter 22

Chapter 22

22-23

P22-7 (Concluded) ** (1) (2) (3) InflationAdjusted Lost Periodic Contribution Margin Saved with CIM (1) (2) $212,000 224,800 238,200 252,400 267,600 283,800

Year 1 2 3 4 5 6

Lost Periodic Contribution Margin Saved with CIM $200,000 200,000 200,000 200,000 200,000 200,000

Annual 6% Inflation Adjustment (1 + .06) = 1.060 (1 + .06)2 = 1.124 (1 + .06)3 = 1.191 (1 + .06)4 = 1.262 (1 + .06)5 = 1.338 (1 + .06)6 = 1.419

22-24

Chapter 22

CASES C22-1 Some of the factors that affect the decision of whether or not to delay the investment in new cleaning equipment are given below. Each factor can have two sides (i.e., delay versus no delay) depending upon the circumstances involved. (a) Unemployment, inflation rate, and business conditions in general. Business outlook improvingdo not delay. Business outlook deterioratingdelay. All of these factors affect the climate for business and should be considered. (b) Difficulty associated with acquisition and installation of equipment and training of operators. Great difficultydo not delay. Little difficultydelay. The greater the lead time involved, the sooner the equipment should be acquired so that it is ready when needed. (c) Extent of operating efficiency improvements. Greatdo not delay. Littledelay. The greater the efficiency, the less it should be delayed because costs will be saved even though volume does not increase. (d) Inflation rate in cost of equipment. Cost of equipment not expected to increase drasticallydelay. Cost of equipment expected to increase drasticallydo not delay. Company wants to minimize its initial cost outlay. (e) Dependability of present equipment and likelihood of breakdowns. Dependability is gooddelay. Dependability is not gooddo not delay. Company could defer, or have to go ahead with investment due to condition of present equipment. (f) Chance for technological advances in equipment. Gooddelay. No chancedo not delay. If there is a chance that technological advances will develop in the design of the equipment, the company might want to take advantage of the new design. (g) Ability to obtain market advantage by providing better quality service at same or lower price. Gooddo not delay. Poor/neutraldelay. Better service means more customers or justifies higher rates.

Chapter 22

22-25

C22-1 (Concluded) (h) Competitors plans for obtaining similar equipment and achieving market advantage. High probabilitydo not delay. Low probabilitydelay. Company wants to maintain competitive advantage or meet competition. (i) Ability to predict timing and increased volume of demand from new or existing customers. Goodbetter quality of decision; could defer switch longer. Lowless reliable criteria for decision. The better a company is able to predict new business, the more certain It can be of its decision and, possibly, the longer it can wait to make a change. C22-2 Knight is probably correct in her assessment that the proposed capital investment framework grants too much freedom to the divisions. Neoglobes long-run performance depends on its capital investments. While divisions must have some responsibility for capital investments for the proposed organization structure to be effective, corporate management must maintain adequate control to direct the future course of the firm. Under the proposed framework, division management controls a substantial portion of the capital budget, and in some years, few funds would be available for investment by corporate management. The present proposal would reduce corporate managements ability to diminish a product line, and it also would impair managements ability to have adequate funds available for investment in new businesses. Capital investment procedures should involve both division and corporate managements in such a way that division management still should be able to influence the future direction of the firm. Such procedures might include classification of capital projects into groups, some of which could be approved by division management without corporate management study. An alternative to the Neoglobe capital investment program might have the following features: (a) All proposed investment projects would be classified according to their naturereplacement, cost savings, expansion. (b) Replacement and cost savings projects could be adopted by division management alone, without approval of corporate management, provided an individual project did not exceed a specified dollar limit and the total of such projects did not exceed another specified dollar limit. The dollar limits would reflect the nature and size of each divisions operations. (c) All expansion projects, or other projects that exceed the dollar limit, would be submitted to corporate management for evaluation and approval.

22-26

Chapter 22

C22-3 The process of planning for and evaluating long-term commitments of resources is normally referred to as capital expenditure planning, evaluating, and control, or capital budgeting. The capital budget is distinct in that it focuses on the longterm effect of resources committed. Its primary objectives are to provide management with (1) a formal process to chart its future course, (2) a means of ranking and selecting among alternative resource commitments to maximize return on investment, and (3) a program for ongoing evaluation of extant resource commitments. Any significant resource commitment is viewed as a project. Hence, the capital budget is composed of projects, some of which are in process and some of which are proposed. Each project affects significant periods of time in the ongoing life of a company. A project often involves the evaluation of alternatives and the purchase of such assets as property, plant, and equipment. It should also consider, however, any proposal or program that requires a significant resource commitment over an extended period, such as the development of new products, opening new markets, and the design and development of major computer programs. Once resources have been committed to a particular project, the project requires ongoing evaluation; i.e., are the projects objectives being met? If not, it needs to be evaluated in terms of whether the project should be retained as is, modified if possible, or abandoned. McAngus can make significant use of capital expenditure planning, evaluating, and control. At the division level, projects will need to be defined in terms of those elements of the plant, or operation of the division, over which the manager has control. On the basis of the facts given, the division manager has authority to operate his or her plant essentially as if it were an independent company. Hence, anything affecting operations, which has required or will require significant resource commitment over a significant period of time, should form an integral part of that divisions capital budget. At the top management level, the president may view each division as a project, particularly for evaluation purposes. The other described activities of top management (investigating and evaluating such things as new markets, etc.) are projects in the capital budgeting sense. These and other new proposals may be defined, analyzed, and evaluated using a variety of available techniques. C22-4 (1) Arnetts revision of the first proposal described in the case can certainly be considered a violation of the Standards of Ethical Conduct. Arnett discarded the reasonable projections and estimates after being questioned and pressured by Earle, and used figures that have only a remote chance of occurring. By doing this, Arnett violated the standard of objectivity (which requires that the management accountant communicate information fairly and objectively and disclose fully relevant information that could reasonably be expected to influence an

Chapter 22

22-27

(2)

(3)

(4)

intended users understanding of the report presented). By altering the analysis, Arnett also violated the standard of integrity (which requires that the management accountant (1) refrain from engaging in an activity that would prejudice his or her ability to carry out the required duties ethically, and (2) communicate unfavorable as well as favorable information, professional judgments, and opinions). Arnett also violated the standard of competence (which requires that the management accountant prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information). Based on the facts in the case, Earle was certainly in violation of the Standards of Ethical Conduct as a result of pressuring a subordinate to prepare a proposal with data that were false and misleading. Earle has violated the standards of competence (failed to perform professional duties in accordance with . . . technical standards; and failed to prepare complete and clear reports and reliable information), integrity (engaged in an activity that would prejudice his or her ability to carry out required duties ethically, actively or passively subverted the attainment of the organizations legitimate and ethical objectives, failed to communicate unfavorable as well as favorable information and professional judgments or opinions, and supported activity that would discredit the profession), and objectivity (failed to communicate information fairly and objectively and did not disclose fully all relevant information that could reasonably be expected to influence an intended users understanding of the report presented). The elements of the projection and estimation process that are compromised because of a predetermined, misleading outcome include: (a) the quality of the base data, (b) the quality of the assumptions used, (c) the probability of the projection occurring, and (d) the credibility of the people submitting the projection. The internal controls Fore Corporation could implement to prevent unethical behavior include: (a) approval of all formal capital expenditure proposals by the controller and/or the board of directors, (b) designating a non-accounting/finance manager to coordinate capital expenditure requests and/or segregating duties during the preparation and approval of capital expenditure requests, (c) requiring all capital expenditure proposals be reviewed by senior operating management, which includes the controller, before the proposals are submitted for approval, and (d) requiring the internal audit staff to review all capital expenditure proposals or contracting with external auditors to review the proposal if the corporation does not have sufficient personnel.

22-28

Chapter 22

C22-5 (1) Referring to the specific standards in the IMAs Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management, the conduct of H. Dodge and G. Watson is unethical as discussed below: (a) H. Dodges first revision of the proposal for the warehouse conversion was unethical because Dodges actions violate the following standards: Competence. Although the estimates used in the analysis are based on managements judgment, Dodges action in changing reasonable estimates to remote assumptions is unethical. Management accountants have the responsibility to prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information. Integrity. Dodge has the responsibility to avoid conflicts of interest, refrain from subverting the attainment of the organizations legitimate and ethical objectives (profitability), and refrain from engaging in or supporting any activity that would discredit the profession. Objectivity. Dodge has the responsibility to communicate information fairly and objectively and to disclose fully all relevant information that can influence an intended users understanding. (b) G. Watsons conduct in giving H. Dodge specific instructions on preparing the second revision of the proposal is unethical because Watsons conduct violates the following specific standards: Competence. Watson has the responsibility to perform his professional duties in accordance with relevant technical standards, such as using conservatism and realistic estimates in the net present value analysis. Management accountants should prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information. Confidentiality. Watson should refrain from using or appearing to use confidential information acquired in the course of his work for unethical advantage for personal gain (saving on commuting time and costs). Integrity. Watson has the responsibility to advise all parties of any potential conflict of interest. Watson should refuse any favor (the warehouse reducing his commuting time) that would appear to influence his actions. Watson should communicate unfavorable as well as favorable information and professional judgments and opinions. Objectivity. Watson has the responsibility to disclose fully all relevant information that can influence an intended users understanding of the analysis.

Chapter 22

22-29

C22-5 (Concluded) (2) Steps recommended by the Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management that H. Dodge should follow in attempting to resolve this situation are as follows: (a) Dodge should first investigate and see if Evans Company has an established policy for resolving conflict, and if such a policy exists, Dodge should follow it. (b) Since it appears that G. Watson, Dodges superior, is involved, there is no need to confront Watson or discuss this issue with Watson any further. Dodge should present the situation to the next higher level, the vice president of finance, for resolution. (c) if Dodge does not receive any satisfaction, Dodge should continue to successively higher levels, including the audit committee and the board of directors, if necessary. (d) Dodge should clarify the concepts of the issue at hand in a confidential discussion with an objective advisor, i.e., a peer. (e) If the situation is still unresolved after exhausting all levels of internal review, Dodge will have no recourse but to resign and submit an informative memorandum to an appropriate representative of the organization. (f) Unless legally bound (which does not appear to be the case in this situation), it is inappropriate to communicate this situation to authorities or individuals outside the organization. (g) Dodge may consult with personal legal counsel.

C22-6 (1) By referring to the IMAs Standards of Ethical Conduct and taking into consideration the specific standards of competence, confidentiality, integrity, and objectivity, L. Forrest should evaluate B. Rollands directives as follows: Competence. Forrest has a responsibility to present complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. Rolland does not wish the report to be complete or clear, and has provided some information that is not totally reliable. Confidentiality. Forrest should not disclose confidential information outside of the organization; but it also appears that Rolland wants to refrain from disclosing information to the board of directors that it should know about. Integrity. Rolland is engaging in activities that could prejudice him from carrying out his duties ethically. In evaluating Rollands directive as it affects Forrest, Forrest has an obligation to communicate unfavorable as well as favorable information and professional judgments or opinions.

22-30

Chapter 22

Objectivity. The responsibility to communicate information fairly and objectively, as well as to disclose fully all relevant information that could reasonably be expected to influence reports and recommendations presented, is being hampered. The board of directors will not have the full scope of information they should have when they are presented with the analysis. (2) By referring to the Standards of Ethical Conduct, L. Forrest should take the following steps to resolve this situation: (a) Forrest should first investigate and see if IDI has an established policy for resolution of ethical conflicts and, if so, follow those procedures. (b) If this policy does not resolve the ethical conflict, the next step would be for Forrest to discuss the situation with his supervisor, Rolland, and see if he can obtain resolution. One possible solution may be to present a base case and sensitivity analysis of the investment. Forrest should make it clear to Rolland that he has a problem and is seeking guidance. (c) If Forrest cannot obtain a satisfactory resolution with Rolland, Forrest could take the situation up to the next layer of management, and inform Rolland that is being done. If this is not satisfactory, Forrest should progress to the next level, and eventually to all higher levels of management until the issue is resolved (i.e., the president, audit committee, or board of directors). (d) Since Rolland has instructed him not to discuss the situation with anyone else at IDI, Forrest may want to have a confidential discussion with an objective advisor to clarify relevant concepts and obtain an understanding of possible courses of action. Forrest may want to talk to a close professional friend or the IMA Ethics Hotline for this purpose. (e) If Forrest cannot satisfactorily resolve the situation within the organization, he may resign from the company and submit an informative memo to an appropriate person in IDI (i.e., the president, audit committee, or board of directors). (f) Forrest may consult with personal legal counsel.