CHAPTER 16

Capital Expenditure Decisions

ANSWERS TO REVIEW QUESTIONS
16-5 (1) The decision rule used to accept or reject an investment proposal under the netpresent-value method is stated as follows: Accept the proposal if the net present
value is zero or positive.
(2) The decision rule used to accept or reject an investment proposal under the internalrate-of-return method is as follows: Accept the investment proposal if its internal rate
of return is equal to or greater than the hurdle rate.
16-8 Four assumptions underlying discounted-cash-flow analysis are as follows:
(1) In the present-value calculations, all cash flows are treated as though they occur at
year end.
(2) Discounted-cash-flow analyses treat the cash flows associated with an investment
project as though they were known with certainty.
(3) Both the NPV and IRR methods assume that each cash inflow is immediately
reinvested in another project that earns a return for the organization. In the NPV
method, each cash inflow is assumed to be reinvested at the same rate used to
compute the projects NPV. In the IRR method, each cash inflow is assumed to be
reinvested at the same rate as the projects internal rate of return.
(4) A discounted-cash-flow analysis assumes a perfect capital market. In a perfect capital
market, money can be borrowed or lent at an interest rate equal to the cost of capital
(or hurdle rate) used in the analysis.
16-18 The profitability index (PI) is defined as the present value of cash flows, exclusive of the
initial investment, divided by the initial investment. Investment proposals sometimes are
ranked by their profitability indexes, with a higher PI being ranked higher. Unfortunately,
this method of ranking investment proposals suffers from some of the same drawbacks as
other ranking methods.
16-21 There are two ways to define an investment projects accounting rate of return:
Accounting rate of return = (average incremental revenue average incremental
expenses, including depreciation and income taxes) initial investment.
Accounting rate of return = (average incremental revenue average incremental
expenses, including depreciation and income taxes) average investment.
The accounting rate of return and the internal rate of return on a capital project
generally differ because the accounting rate of return calculation does not take into
account the time value of money.

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16-1

SOLUTIONS TO EXERCISES
EXERCISE 16-37 (25 MINUTES)
1.

The projects payback period is 2.25 years, calculated as follows:

After-Tax
Cash Flows
Year
1 ............................................................................................ $ 50,000
2 ............................................................................................
45,000
st
10,000 (.25 $40,000)
3 (1 quarter) .......................................................................
Total ..................................................................................... $105,000
Initial cost ............................................................................ $105,000

2.

The accounting rate of return is 18.1%, calculated as follows:

Accounting rate of return

3.

average net income

initial investment

$19,000
= 18.1% (rounded)
$105,000

Net present value calculations:

Year
0
1
2
3
4
5
Net present value

After-Tax
Cash Flow
$(105,000)
50,000
45,000
40,000
35,000
30,000

Discount
Factor*
1.000
.862
.743
.641
.552
.476

Present
Value
$(105,000)
43,100
33,435
25,640
19,320
14,280
$ 30,775

*From Table III in Appendix A (r = .16).

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SOLUTIONS TO PROBLEMS
PROBLEM 16-40 (30 MINUTES)
1.

Yes. This is a long-term decision, with cash flows that occur over a five-year period.
Given that the cash flows have a value dependent on when they take place (e.g.,
cash inflows that occur in earlier years have a higher time value than cash inflows
that take place in later years), discounting should be used to determine whether
Community Challenges should outsource.

2.

Community Challenges is better off to manufacture the igniters.

Outsource:
Annual purchase (400,000 units x $62).. $(24,800,000)
Annuity discount factor (Table IV*: r = .14, n = 5) x
3.433
Net present value $(85,138,400)
Manufacture in-house:
Annual variable manufacturing costs (400,000 units
x $60).
Annual salary and fringe benefits
Total annual cash flow.
Annuity discount factor (Table IV: r = .14, n = 5)
Present value of annual cash flows
New equipment (time 0)..
Repairs and maintenance: $4,500 x (3.433 1.647)
(Table IV: r = .14, n = 3-5)
Equipment sale: $12,000 x .519 (Table III: r = .14,
n = 5).
Net present value.

$(24,000,000)
(95,000)
$(24,095,000)
x
3.433
$(82,718,135)
(60,000)
(8,037)
6,228
$(82,779,944)

Note: Depreciation is ignored because it is not a cash flow.

*Discount factors from the tables in Appendix A.
3.

The company would be financially indifferent if the net present value (NPV) of the
manufacture alternative equals the NPV of the outsource alternative. Thus:
Let X = purchase price
3.433 x 400,000X = $82,779,944
1,373,200X = $82,779,944
X = $60.28 (rounded)

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16-3

PROBLEM 16-43 (50 MINUTES)

1.

See the following table.

2.

See the following table.

3.

See the following table.

4.

The administrator should recommend that the clinic be built, because its net present
value is positive.

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PROBLEM 16-43 (CONTINUED)

Type of Cash Flow
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
20x8
20x9
(1) Construction of clinic
$(390,000) $(390,000)
(2) Equipment purchase
(150,000)
(3) Staffing
$(800,000) $(800,000) $(800,000) $(800,000) $(800,000) $(800,000) $(800,000) $(800,000)
(4) Other operating costs
(200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000) (200,000)
(5) Increased charitable
contributions
250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000
(6) Cost savings at hospital
1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
(7) Cost of refurbishment
(180,000)
(9) Salvage value
290,000
Incremental cash flow
$ 250,000 $ 250,000 $ 250,000 $ 70,000 $ 250,000 $ 250,000 $ 250,000 $ 540,000
$(390,000) $(540,000)
Discount factor*
1.000 .893 .797 .712 .636 .567 .507 .452 .404 .361
Present value
$ 199,250 $ 178,000
$ 39,690 $ 126,750 $ 113,000
$(390,000) $(482,220)
$ 159,000
$ 101,000 $ 194,940
1444444444444444444442444444444444444444443
Sum=$239,410
Net present value

*Table III in Appendix A:

r = .12.

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16-5

PROBLEM 16-51 (45 MINUTES)

1.

Net-present value analysis of the machine replacement:

20x1
Acquisition cost ........................................................
$(1,000,000)
After-tax operating cost savings
[$300,000 (1 .40)] ...............................................

20x2

20x3

20x4

20x5

$180,000

$180,000

$180,000

$180,000

Depreciation tax shield:

Acquisition MACRS
Tax
Year
Cost
Percentage Rate
20x2:
20x3
20x4
20x5

$1,000,000
$1,000,000
$1,000,000
$1,000,000

33.33%
44.45%
14.81%
7.41%

.40
.40
.40
.40

................
................
................
................

133,320
177,800
59,240

Salvage value of old machine:

Cash proceeds from sale .....................................
Gain on sale .......................................... $60,000
Tax rate .................................................. .40
Tax on gain ........................................... $24,000
Total after-tax cash flow ...........................................

Discount factor (Table III in Appendix A) ...............

Present value ............................................................

Net present value ......................................................

60,000
(24,000)
(964,00
0)
1.
000
(964,00
0)

$313,320

.
893
*
$279,795

$357,800

.
797
*
$285,167
Sum = $(95,368)

*Rounded.
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$239,240

.
712
*
$170,339

$209,640

.
636
$133,331
*

PROBLEM 16-51 (CONTINUED)

2.

The machine replacements internal rate of return is between 6% and 8%. The
projects net present value is positive if a 6% discount rate is used, but it is negative
if an 8% discount rate is used.

Year
20x1 .................
20x2 .................
20x3 .................
20x4 .................
20x5 .................
Net present value
3.

Total After-Tax
Cash Flow
(from
requirement 1)
$(964,000)
313,320
357,800
239,240
209,640

6%
Present
Discount
Value
Factor
(using 6%)
1.000
$(964,000)
.943
295,461
.890
318,442
.840
200,962
.792
166,035
$ 16,900

8%
Discount
Factor
1.000
.926
.857
.794
.735

Present
Value
(using 8%)
$(964,000)
290,134
306,635
189,957
154,085
$ (23,189)

The payback period on the machine replacement is between three and four years.

Year
20x2 ..........................................
20x3 ..........................................
20x4 ..........................................
Subtotal ....................................
20x5 ..........................................
Total ..........................................

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Total After-Tax
Cash Inflow
(from requirement 1)
$ 313,320
357,800
239,240
$ 910,360< $964,000 = initial net cash outflow
209,640
$1,120,000> $964,000 = initial net cash outflow

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16-7

PROBLEM 16-51 (CONTINUED)

4.

With a salvage value of zero on the new machine, the machine replacements net
present value is $(95,368). Thus, the after-tax discounted cash flow from the salvage
of the new machine on December 31, 20x5 would have to exceed $95,368. Dividing by
the year 4, 12% discount factor, the after-tax cash flow would have to exceed
$149,950 ($95,368 .636, rounded). Let X denote the new machines salvage value on
December 31, 20x5. Then the gain on sale will also be X, since the new machine will
be fully depreciated. The tax on this gain will be .40X. Therefore, the following
equation must hold:
X .40X

$149,950

.60X

$149,950

$249,917 (rounded)

Thus, the salvage value of the new machine must exceed $249,917 in order to turn
the machine replacement into a positive net-present-value project.
Check:
Cash proceeds from sale of new machine ..............................................
Gain on sale .......................................................................
$249,917

.40
Tax rate ...............................................................................
Tax on gain .........................................................................
$ 99,967
After-tax cash flow from sale ...........................................
Discount factor (4 years, 12%) .........................................
Present value of cash flow from sale ..............................

$249,917
(99,967)
$149,950
.636
$ 95,368

Adding the $95,368 to the negative net present value calculated in requirement (1) of
$(95,368), the new net present value is zero.

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Solutions Manual

PROBLEM 16-52 (35 MINUTES)

1.

(a) Mall restaurant:

Net after-tax cash inflows ........................................................................... $ 50,000
Annuity discount factor (r = .10, n = 20) ................................................ 8.514
Present value of annual cash flows ........................................................... $425,700
Cash outflow at time 0 ................................................................................
400,000
Net present value ......................................................................................... $ 25,700
(b) Downtown restaurant:
Net after-tax cash inflows ........................................................................... $ 35,800
Annuity discount factor (r = .10, n = 10) ................................................ 6.145
Present value of annual cash flows ........................................................... $219,991
Cash outflow at time 0 ................................................................................
200,000
Net present value ......................................................................................... $ 19,991

2.

Profitability index =

present value of cash flows, exclusive of initial investment

initial investment

(a) Mall restaurant:

Profitability index =

$425,700
= 1.06 (rounded)
$400,000

(b) Downtown restaurant:

Profitability index =

$219,991
= 1.10 (rounded)
$200,000

3.

The mall site ranks first on NPV, but the downtown site ranks first on the profitability
index.

4.

The two proposed restaurant projects have different lives, which makes it
particularly difficult to rank them. It is not clear what will happen in years 11 through
20 if the downtown site is chosen.

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16-9

PROBLEM 16-53 (30 MINUTES)

1.

Payback period =

initial investment
annual after - tax cash inflow

(a) Mall restaurant:

Payback period =

$400,000
= 8 years
$50,000

(b) Downtown restaurant:

Payback period =

2.

Accounting rate of return =

$200,000
= 5.6 years (rounded)
$35,800

average average incremental expenses

incremental (including depreciation and

revenue
income taxes)

initial investment

(a) Mall restaurant:

Accounting rate of return =

$50,000
= 12.5%
$400,000

(b) Downtown restaurant:

Accounting rate of return =

$35,800
= 17.9%
$200,000

3.

The owners criteria will lead to selection of the downtown site.

4.

Neither the payback period nor the accounting-rate-of-return method considers the
time value of money. Moreover, the payback method ignores cash flows beyond the
payback period.
On the positive side, both methods can provide a simple means of screening a
large number of investment proposals.

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PROBLEM 16-54 (35 MINUTES)

1. Payback period = 3 years*
*Initial investment = $120,000 = (3)($40,000) = sum of net incremental cash flows during first 3 years.

2. Accounting rate of return (ARR) using initial investment:

ARR = ($74,000* - $59,000) / $120,000 = .125
*$74,000 =($70,000 + $72,000 + $74,000 + $76,000 + $78,000) / 5
$59,000

= [$30,000 + $32,000 + $34,000 + $38,000 + $41,000 + (5)($24,000)] / 5

3. Accounting rate of return (ARR) using average investment:

ARR = ($74,000* - $59,000*) / $60,000 = .25
*See requirement (2).
Average investment using straight-line depreciation = ($120,000

+ 0) / 2 = $60,000

4. Discounted-cash-flow methods take into account the time value of money, whereas
the payback and accounting-rate-of-return methods do not.
5. No, this would not be ethical. The theaters board is entitled to fair and objective
information about the project. (Refer to the ethical standards for managerial
accountants listed in Chapter 1 of the text, particularly the section entitled Objectivity.)

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