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CHY 104
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Tsogbadral Galaabaatar
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Chapter 12: Strategic Investment Decis24ns Chapter 12 Strategic Investment Decisions LEARNING OBJECTIVES Chapter 12 addresses the following questions: LO1 Explain how strategic investment decisions are made. LO2 identify relevant cash flows and perform net present value (NPV) analysis. LO3 Identify the uncertainties of NVP analysis. LO4 Apply alternative methods in analyzing strategic investment decisions. LO5 Identify additional issues to be considered for strategic investment decisions. LO6 Explain how income taxes affect strategic investment decisions cash flows. LO7 Explain how real and nominal methods are used to address inflation in an NPV analysis. These learning questions (LO1 through LO7) are cross-referenced in the textbook to individual exercises and problems. © 2012 John Wiley and Sons Canada, Ltd. 25 Cost Management QUESTIONS 12.1 After a number of years, the present value factors for all discount rates become quite small, and the incremental effect of future cash flows is therefore small.According to the present value tables, after about 20 years, the incremental values at rates above 8 to 10% are small (less than 20% of the original value).If these cash flows are small, but include error, the size of error would also be small and likely have little effect on the overall analysis. 12.2 If several projects are being analyzed, their NPVs can be summed to determine the NPV for that group or portfolio of projects, whereas IRR can be neither summed nor averaged.In addition, NPV provides information about the value of the projects in terms of today’s dollars.If projects are of different sizes, requiring large and small investments, NPV reflects these differences.IRR provides only a rate of return, and comparing rates of return does not take into consideration the size of return.In addition, the net present value method is computationally simpler than the internal rate of return method. Determining IRR can be time consuming, particularly for projects having uneven cash flows. However, the use of a spreadsheet reduces the effort considerably. An important difference between the two methods is that the IRR method assumes cash inflows can be reinvested to earn the same return that the project would generate.However, it may be difficult for an organization to identify other opportunities that could achieve the same rate when IRR is high.In contrast, the NPV method assumes that cash inflows can be reinvested and earn the discount rate—a more realistic assumption.If the discount rate is set equal to the organization’s cost of capital, then alternative uses of cash would include paying off creditors or buying back stock.Therefore, if the results of analyses using the two methods are not the same, the NPV method is preferable. Both methods are used widely in business.One reason for the continued use of IRR is that many people find it intuitively easier to understand than NPV.In addition, managers may want to compare the IRR on prior projects to current project return rates as they consider new investment. 12.3 (a) Net present value (NPV) Pros: • NPV is more accurate than the payback and accrual accounting rate of return methods because it reflects the time value of money. • Under NPV, discounted cash flows reflect today’s dollars, so several different projects can be easily compared to determine the one with the highest NPV. Cons: • It is sometimes more difficult to estimate cash flows and choose an appropriate discount rate for NPV than finding the internal rate of return or calculating payback or an accounting rate of return. © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 26 (b) Internal Rate of Return (IRR) Pros: • Many managers find IRR intuitively easier to understand than NPV • IRR has the same advantage as NPV of including the time value of money. • IRR can be used to compare potential projects (choose the one with highest IRR). Cons: • Assumes cash flows can be reinvested at the IRR • When comparing projects, IRR does not take into consideration size of investment and may be inappropriate when managers need to choose among competing projects because capital is constrained. • IRRs from several projects cannot be summed or averaged, while net present values can. • IRR is computationally more difficult than NPV and the other methods, particularly with uneven cash flows. (c) Payback Method Pros: • Used extensively, particularly outside of the U.S. • Focuses on high risk of long payback period Cons: • Does not incorporate time value of money • Ignores cash flows received after the investment is recovered (d) Accrual Accounting Rate of Return Pros: • Use for division or department performance because data is readily available Cons • Cost of investment is double-counted (amortization is included in the numerator, and the investment is the denominator) • Not appropriate for capital budget decisions because it does not include the time value of money 12.4 Estimating future cash flows becomes more difficult over longer periods of time because the uncertainties increase.Changes in economic, political, and consumer tastes that affect cash flows cannot be easily predicted.More information is usually available about near- term economic factors than long-term. 12.5 Future cash flows are discounted with present value factors that become increasingly small across time to reflect the fact that investors forego interest on cash flows that are received in the future relative to cash flows that are received today and could be invested © 2012 John Wiley and Sons Canada, Ltd. 27 Cost Management today.This discounting reflects the opportunity cost (interest foregone) when money is received in the future instead of today. 12.6 A nominal discount rate includes a factor for inflation, and the real rate does not.Both rates include a risk-free rate and a risk premium.Using a nominal approach, different cash flows can be inflated differentially.For example, gasoline prices might inflate at a different rate than wages.If different types of cash flows are differentially inflated to better reflect future expectations, the preciseness of the estimation and analysis process increases and information quality increases. 12.7 Real assets tend to increase in nominal value under inflation, while monetary assets tend to remain fixed.If a firm has cash in a bank earning interest, the after-tax return could be less than the inflation rate.Therefore the firm’s cash would be losing purchasing power over time.In this case it would be better for the firm to invest in a real asset that increases at the inflation rate or greater. 12.8 Net present value.All investments with a positive net present value would be accepted, assuming that the cost of capital is constant across investments. 12.9 Requiring a higher return rate for projects in developing countries may be the firm's way of coping with increased problems of uncertainty and risk.Less developed countries usually have less stable political systems, economies, inflation rates, and consumer markets.In addition, infrastructure such as roads and utilities is sometimes unreliable, so production and transportation problems could occur more frequently. These factors increase the risk of doing business in developing countries. From the host government's point of view, if a higher rate of return is not permitted under such circumstances, the investment would probably never have been made at all, and the developing country would be worse off as a result.The firm, however, must be careful to avoid any perception of exploitation, as the long-term reputation effect could be devastating. 12.10 There are two reasons to incorporate tax effects more formally into NPV analyses.From an accounting standpoint, tax regulations permit a shift of both the amount and the timing (sometimes permanently) of taxes; this will have an effect on present values.If tax savings based on current tax rules are not incorporated into the analysis, these effects are not captured and the analysis is less accurate.From a mathematical standpoint, the factors in the tables are not linearly related (all of the formulas have exponents); e.g., the present value factor for 20% is not one-half of the factor for 10%. 12.11 The return on the investment portfolio represents the centre's opportunity cost for funds.They can earn at least that return; therefore, any other investment must yield a higher return. 12.12 After a number of years, the present value factors for all discount rates become quite small, and the incremental effect of future cash flows is therefore small. According to the present value tables, after about 15 years, the incremental values at rates above 8 to 10% © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 28 are small. For example, at a discount rate of 15%, after 17 years the present value factor is 0.093, meaning that the $1 inflow 17 years from today is worth to us just $0.093 when measured in today’s dollars 12.13 The present value of an ordinary annuity table reflects the value of uniform cash flows over time. If the cash flows were not discounted over time, the annuity factor would be equal to the number of time periods in which cash flows are expected to occur. However, the discount increases over time, so the incremental present value for each time period decreases. Annuity factors increase over time because they are cumulative; they reflect cash flows for additional time periods. However, the incremental increase for each annuity factor becomes smaller over time. This is in contrast to the present value table, which reflects the value of a single sum in the future. The factors decrease each time period to reflect the time value of money; $1 received further into the future is worth less than $1 received sooner. 12.14 Organizations expect to accept projects which contribute to organizational strategy and for which the rate of return appropriately reflects the business risk. The following types of boundary controls help to ensure that subordinates comply with top management’s investment policies: (1) Required rate of return: Each firm has a different risk appetite and boundaries such as hurdle rates communicate these risk preferences to subordinates and constrain them from investing in projects that exceed the firm’s risk appetite. (2) Types of capital projects to consider: Each organization has an overarching strategy, and a boundary control that restricts the types of projects to consider should reduce the likelihood that investments will be made in projects that do not support planned strategies. (3) Maximum capital budget that can be spent without top management approval: To facilitate timeliness of decision-making, especially in industries that compete on cutting edge technology, subordinates are often given investment decision rights. Placing a maximum amount on decision rights for capital expenditures can improve organizational cash flow planning and reduce the likelihood that large investments will fail to meet top management’s strategic plans. 12.15 When an NPV analysis includes taxes, the terminal value of any asset that is sold needs to be adjusted for the effects of taxes on a loss or gain because the tax consequences will affect cash flows during the year the sale is made. If an asset is sold at its tax basis, no taxes will be paid. © 2012 John Wiley and Sons Canada, Ltd. 29 Cost Management MULTIPLE-CHOICE QUESTIONS 12.16 In analyzing capital budgeting decisions, a number of methods are commonly used. Which of the following methods does not involve the discounting of cash flows? a) Internal rate of return method b) Net present value method c) Real options method d) Payback method Ans: D Use the following information to answer Question 12.17 to 12.20: Juno Manufacturing Ltd. isconsidering replacing its existing equipment with an automated machine for $133,950. Junoamortizes its capital assets using the straight-line amortization method. Juno estimates that thenew machine will reduce production costs by $28,500 per year and that it has a useful life of6 years. 12.17 What is the internal rate of return? a) 6.84% b) 7.46% c) 7.66% d) 8.14% Ans: B Use excel or a financial calculator to solve this problem. 12.18 What is the payback period? a) 1.27 years b) 4.00 years c) 4.70 years d) 6.00 years Ans: C ($133,950 / $28,500 = 4.7 years) 12.19 What is the net present value if the required rate of return is 8%? a) $(2,194.50) b) $0.00 c) $1,909.50 d) $37,050.00 Ans: A © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 30 12.20 What is the accounting rate of return? a) 3.55% b) 4.61% c) 9.50% d) 21.30% Ans: B © 2012 John Wiley and Sons Canada, Ltd. 31 Cost Management EXERCISES 12.21 Time Value of Money A. Using tables, the answer is ($8,000 x 0.5835) = $4,668. Using Excel, the answer is $4,667.92. B. Using the tables, the answer is ($125 x 1.7908) = $223.88. Using Excel, the answer is $223.86. C. Using tables, the answer is ($10,000 x 0.7473) = $7,473. Using Excel, the answer is $7,472.58. D. Using tables, the answer is ($1,000 x 0.5066) = $506.6 Using Excel, the answer is $506.63. 12.22 Capital Budgeting Process The proper sequence is:4, 1, 5, 2, 3, and 6. 12.23 Payback in Months -- International Netherlands Group Payback = $700,000/$2,900,000 = 0.24 years 0.24 years × 12 months per year = 2.88 months 12.24 NPV Calculations with Taxes - Overnight Laundry Cash Flow Timeline: Time 0 Years1-10 Year 10 Investment $(96,000) Incremental cash flows: Annual Savings $25,000 Taxes (5,128) (a) Net cash flow $19,872 Terminal value $6,000 (a) The salvage value is ignored for income tax amortization, so the annual amortization = $96,000/10 years = $9,600 per year Taxes per year = ($25,000 - $9,600) * 33.3% = $5,128 © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 32 NPV calculation: NPV = $(96,000) + $19,872 (PVFA 18%, 10 years) + $6,000 (PVF 18%, 10 years) = $(96,000) + ($19,872 x 4.4941) + ($6,000 x0.1911) = $(96,000) + $89,307 + $1,147 = ($5,547) Any tax affect of disposal value has been ignored in this question. 12.25 NPV and IRR Calculations - Axel Corporation A. The net present value is $30,000 (5.0188) - 150,000 = $564. B. The internal rate of return is a little higher than 15%.Using Excel, the actual rate is 15.098%. 12.26 NPV, IRR, ARR and Payback Methods - Amaro Clinic A. The net present value is ($5,000 x 5.2161) - 20,000 = $6,080 B. The factor for the internal rate of return must be 20,000 = $5,000*Factor Factor = 4.0 From the PVFA tables for 10 year, it would be just over 20% (PVFA = 4.192) Using Excel’s IRR function, the rate is 21.4% C. Assuming straight-line amortization, the earnings will be $5,000 - $20,000/10 = $3,000 The accounting rate of return is $3,000/20,000 = 15% D. The payback period is $20,000/$5,000 = 4 years 12.27 NPV, ARR and Payback Methods – Moosehead Community Centre A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). © 2012 John Wiley and Sons Canada, Ltd. 33 Cost Management A. NPV Cash Discount PresentValue Year Savings factor @12% 1 $5,200 0.893 4,643.08 2 4,800 0.797 3,826.56 3 4,400 0.712 3,131.92 4 3,600 0.636 2,287.80 5 3,200 0.567 1,815.68 6 2,800 0.507 1,418.48 7 2,200 0.452 995.06 8 1,800 0.404 727.02 PVof CashFlows 18,845.60 Less:Costof Investment (20,000.00) NetPresentValue (1,154.40) UsingExcel:PVof CashFlows 18,845.58 Less:Costof Investment (20,000.00) NetPresentValue (1,154.42) B. ARR Initial Investment 20,000 Life 8years ExpectedReturn 12% YearAmount 1 5,200 Averageannual savings 2 4,800 =28,000/ 8years 3,500 3 4,400 4 3,600 Annual amortization 5 3,200 =20,000/ 8years 2,500 6 2,800 7 2,200 Incremental income 8 1,800 =savings- amortization 1,000 Total 28,000 ARR Incremental Income/ Initial Investment =1,000/ 20,000= 5.00% © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decision34 C. PaybackPeriod Balanceto CashFlow berecovered Investment 20,000 Year-1 5,200 14,800 2 4,800 10,000 3 4,400 5,600 4 3,600 2,000 5 3,200 6 2,800 7 2,200 8 1,800 Year5cashflowof $3,200will coverthebalanceof $2,000 Todeterminewhenduringyear5: balance/ amountof year5cashflow 2,000/3,200= 0.6250 years thisisequal to7.5months Theinvestmentwill berecoveredin5.625yearsor5years7.5months D. Based on the above analysis this snow plough would not be recommended. The net present value is negative indicating that the cost savings are not sufficient enough to cover the cost of the snow plough. The payback period is longer than 5 years which exceeds their four-year cut-off for new project pay back periods. The accrual accounting rate of return is only 5% which does not come close to their minimum expected return of 12%. 12.28 Present Value and Future Value Calculations - Crown Corporation A. The PVFA for four payments discounted at 6% is 3.4651.Thus, the present value of the note is $1,000 x 3.4651 = $3,465.With the down payment, the total is $4,465. B. Because this is a single payment the factor is a present value single amount of 0.7350, so the total is $4,000 x .7350 = $2,940.With the down payment it becomes a total present value selling price of $3,940. C. The selling price of the equipment is $5,000 no matter how the employee gets the cash and what Crown does with the $5,000.The future value factor for three years hence is 1.2250, yielding:$5,000 x 1.225 = $6,125. © 2012 John Wiley and Sons Canada, Ltd. 35 Cost Management 12.29 NPV, IRR, Payback Methods, and ARR – KTI Inc A. Net Present Value: ($320,000 Initial Investment ) Working Capital 20,000 ($300,000 ) Annual Cash Flows Net Income 50,000 Add: Depreciation * 60,000 x3.790 Total Annual Cash flows 110,000 8 $416,988 Terminal Value Residual Value 20,000 Requirement of Working Capital ($20,000) 0 Net Present Value $116,988 *Depreciation Expense = ($320,000 – $20,000) ÷ 5 = 60,000 B. IRR: ($300,000) + $110,000 X + 0 = 0 X = 2.7273 20% = 2.9906 X% = 2.7273 25% = 2.6893 X = (2.9906 – 2.7273) ÷ (2.9906 – 2.6893) = 0.8739 0.8739 x 5% = 4.3694% X = 24.3694% IRR as per Excel = 24.319% C. Payback Period Annual Cash Flows: $50,000 + $60,000 = $110,000 $320,000 ÷ $110,000 = 2.73 years D. Accrual Accounting Rate of Return: $50,000 ÷ $300,000 = 16.67% E. Yes, KTI should invest in the project, because NPV is greater than 0, IRR = 24%, and ARR = 16.67% are greater than the required rate of return,10%. Although the © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 36 acceptable cut off period is greater than the company’s benchmark, it is close to the required payback period. Based on the quantitative analysis, the project will bring financial benefit to KTI. 12.30 NPV Analysis with Taxes and CCA (Appendix 12A) Year0 Year1 Year2 Year3 Year4 Year5 Year6 Year7 Costofnewmachine (1,200,000) Installationcosts (130,000) Totalcostofnewmachine (1,330,000) Saleofoldmachine 75,000 NetInvestment (1,255,000) AnnualSavings 130,000 140,000 150,000 175,000 180,000 185,000 195,000 Costsavings 45,000 Maintenancefees (40,000) Salvageofnewmachine 120,000 Salvagelostonoldmachine (30,000) Totalannual savings 130,000 140,000 195,000 175,000 140,000 185,000 285,000 Depreciationoncostofnewmachine 15% (199,500) (199,500) (199,500) (199,500) (199,500) (199,500) (199,500) Totaltaxableincome (69,500) (59,500) (4,500) (24,500) (59,500) (14,500) 85,500 Incometaxes 35% (24,325) (20,825) (1,575) (8,575) (20,825) (5,075) 29,925 Totalannual savingsnetoftaxes (1,255,000)154,325 160,825 196,575 183,575 160,825 190,075 255,075 Discountrate;factor 12% 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 Presentvalueofcashflows 825,505 137,797 128,210 139,922 116,662 91,252 96,292 115,370 Netpresentvalue (429,495) NPVasperExcel (429,480) The company should not buy the new machine because the NPV is negative. 12.31 Relevant Cash Flows, NPV Analysis with Taxes and CCA (Appendix 12A) – Karisma Ltd. A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. Assumptions: Initial Investment 60,000 Annual Savings Life 5 Materials 14,000 Lab Terminal Value - our 6,000 After-tax Rate of Return 7% Real Interest Rate 10% CCA Rate 20% Income Tax Rate 30% Annual Cost Savings Schedule © 2012 John Wiley and Sons Canada, Ltd. 37 Cost Management Year 1 2 3 4 5 20, 0 0 Annual Cost Savings 20,000 20,000 20,000 0 20,000 6,00 Less Income Taxes 6,000 6,000 6,000 0 6,000 Total 14,000 14,000 14,000 14,000 14,000 Calculation of Amortization Tax Shield CCA Rate 20% declining balance st ½ year on 1 year 10,80 CCA Deduction 6,000 0 8,640 6,912 5,530 Tax Savings (tax shield) 1,800 3,240 2,592 2,074 1,659 Summary of Cost Savings 14, 0 0 Incremental Cost Savings 14,000 14,000 14,000 0 14,000 2, 0 7 Tax Savings 1,800 3,240 2,592 4 1,659 16, 0 7 Total 15,800 17,240 16,592 4 15,659 Present Value of Cost Savings 61,779 Less Initial Investment (60,000) Net Present Value 1,779 B. Profitability Index = Present Value of Cash Inflows Present Value of Investment cash outflows = 61,779= 1.0297 60,000 C. Summary of Cost Savings Incremental Cost 14,000 14,000 14,000 14,000 Savings 1 © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Deci38ons 4 , 0 0 0 3,2 4 Tax Savings 1,800 0 2,592 2,074 1,659 Total 15,800 17,240 16,592 16,074 15,659 Initial Investment Cost Savin gs Cumulative Balance to Recover 15,80 0 15,800 44,200 33,04 0 17,240 26,960 49,63 2 16,592 10,368 65,70 6 16,074 15,659 The investment will be fully recovered in year 4. To determine when, divide the balance after year 3 by the total to be recovered in year 4. 10,368/16,074 = 0.645 years .645 years = 7.74 months The payback period is 3.645 years or 3 years 7.7 months D. Based on the above analysis the new machine should be purchased. The net present value is positive indicating that the cost savings are sufficient enough to cover the cost of the machine. The profitability index is greater than one, although this would be more beneficial if they were ranking various projects. The payback period is less than the four- year cut-off required for new project pay back periods. © 2012 John Wiley and Sons Canada, Ltd. 39 Cost Management 12.32 Relevant Cash Flows, NPV Analysis with Taxes and Inflation (Appendix 12A) -Clearwater Bottling Company A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. Cash Flow Timeline: Time 0 Years1-5 Year 10 Investment $(100,000) Incremental cash flows: Annual Savings $20,000 (a) Taxes (0) (b) Net cash flow $20,000 Terminal value $0 (a) Savings = Additional contribution margin – Increase in fixed costs = ($9 - $7) x 20,000 cases - $20,000 = $20,000 (b) Amortization = $100,000/5 years = $20,000 per year Incremental Taxes = (Savings – Amortization) * 25% = ($20,000 - $20,000) * 25% = $0 B. The NPV for this part can easily be calculated manually as shown below. The sample spreadsheet shows the NPV to be $(27,904). The difference is due to rounding. NPV = $(100,000) + $20,000 (PVFA 12%, 5 years) NPV = $(100,000) + $20,000 x 3.605 NPV = $(27,900) C. To determine the amount of sales needed to bring the NPV to zero, first re-write the incremental cash flows substituting Q for the volume of cases sold. Cash Flow Timeline: Time 0 Years1-5 Year 10 Investment $(100,000) Incremental cash flows: Annual contribution margin $2Q (a) Incremental fixed costs (20,000) Incremental taxes ($0.5Q - $5,000) (b) Net cash flow $1.5Q - $15,000 Terminal value $0 (a) Annual contribution margin per case (Q) = ($9 - $7)Q = $2Q (b) Amortization = $100,000/5 years = $20,000 per year Incremental Taxes = ($2Q – $20,000) * 25% = $0.5Q - $5,000 © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 40 Next, set the NPV equal to zero and solve for Q: 0 = $(100,000) + ($1.5Q - $15,000) x 3.6048 0 = $(100,000) + 5.4072Q - $54,072 5.4072Q = $154,072 Q = 28,494 cases 12.33 NPV Analysis - Parish County This problem is most easily solved in steps. First determine the present value of the terminal cash flow: Terminal value = $400,000 x 20% = $80,000 Present value = $80,000 x (PVF, 10%, 5 years) = $80,000 x 0.6209 = $49,672 Subtract the present value of the terminal value from the investment to determine the present value needed from annual savings to justify the purchase: Minimum PV of annual savings = $400,000 - $49,672 = $350,328 Finally, determine the annual savings needed to achieve the present value calculated above.The following calculation assumes that the annual savings would be identical during each of the 5 years. Savings x (PVFA, 10%, 5 years) = $350,328 Savings x 3.7908 = $350,328 Savings = $350,328/3.791 = $92,415 The company must generate at least $92,415 per year in savings to justify purchasing the plane. © 2012 John Wiley and Sons Canada, Ltd. 41 Cost Management 12.34 NPV and Payback with Taxes - Equipment Investment A. Time 0 investment = -$60,000 Years 1-6: Year 1 2 3 4 5 6 Annual saving after-tax $18,000 $18,000 $18,000 $18,000 $18,000 $18,000 Amortization tax savings 4,000 4,000 4,000 4,000 4,000 4,000 Total annual after-tax flows$22,000 $22,000 $22,000 $22,000 $22,000 $22,000 Calculation details: Annual after-tax savings = $30,000 * (1-0.40) = $18,000 Straight-line amortization = $60,000/6 years = $10,000 per year Amortization tax savings per year = $10,000 * 0.40 = $4,000 B. NPV calculation: NPV = -$60,000 + $22,000 x (PVFA 10% 6 years) NPV = -$60,000 + $22,000 x 4.3553 = $35,817 C. To determine the payback period, first summarize the cumulative cash flows from the project: Year Cumulative Cash Inflows 1 22,000 2 44,000 3 66,000 The original investment is $60,000, which is expected to be paid back between 2 and 3 years. If the cash flows are assumed to occur evenly throughout each year, the payback period is 2.73 years [(2 + (60,000 - 44,000)/22,000)]. Because cash flows are identical across years, the payback can also be calculated as follows: $60,000/$22,000 = 2.73 years. 12.35 IRR - Ferris Industries A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. Internal rates of return were calculated using the Excel function IRR. The rates of return are Project IRR 1 15.67% 2 27.32% 3 26.59% 4 28.14% Based solely on the internal rate of return, the projects would be ranked 4, 2, 3, and 1. © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 42 B. There appear to be considerable differences in risk among the projects. Projects 2 and 3 expect negative incremental operating cash flows during some of the years, and project 4 expects zero incremental operating cash flows during 2 of the 6 years. Projects 2, 3, and 4 show more variation across years than project 1. If there is a high rate of technological change in this industry, management may prefer project 2, which pays back most of the investment quickly. 12.36 Alternative Technologies and Capital Budgeting with Taxes - Lymbo Company, Inc. A. Based on the NPV of the two alternatives, the company should choose Alternative 2 with a less negative NPV than Alternative 1. Calculations for each alternative are shown below. Cash Flow Timeline for Alternative 1: Time 0 Years 1-5 Years 6-15 Investment $(100,000) Incremental cash flows: Maintenance Cost $(20,000) $(20,000) Taxes 12,000 (a) 6,000 (b) Net cash flow $ (8,000) $(14,000) (a) Amortization = $100,000/5 years = $20,000 per year Incremental taxes deductions during years 1-5 = (Maintenance cost + Amortization) * 30% = ($20,000 + $20,000) * 30% = $12,000 (b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30% = $20,000 * 30% = $6,000 NPV Calculation for Alternative 1: NPV = $(100,000) + [$(8,000) x (PVFA 12%, 5 years)] + [$(14,000) x (PVFA 12% 15 years – PVFA 12% 5 years)] NPV = $(100,000) + [$(8,000) x 3.6048] + [$(14,000) x (6.8109 – 3.6048)] NPV = $(100,000) + $(28,838) + $(44,886) = $(173,724) Following is a different way to perform the same calculations for Alternative 1: NPV of installation cost $(100,000) NPV of annual maintenance cost $(20,000) x (1-30%) x 6.8109 (95,353) NPV of amortization tax shield $20,000 x 30% x 3.6048 21,629 Total NPV $(173,724) © 2012 John Wiley and Sons Canada, Ltd. 43 Cost Management Cash Flow Timeline for Alternative 2: Time 0 Years 1-5 Years 6-15 Investment $(150,000) Incremental cash flows: Maintenance Cost $(10,000) $(10,000) Taxes 12,000 (a) 3,000 (b) Net cash flow $ 2,000 $ (7,000) (a) Amortization = $150,000/5 years = $30,000 per year Incremental taxes deductions during years 1-5 = (Maintenance cost + Amortization) * 30% = ($10,000 + $30,000) * 30% = $12,000 (b) Incremental taxes deductions during years 6-15 = Maintenance cost * 30% = $10,000 * 30% = $3,000 NPV Calculation for Alternative 2: NPV = $(150,000) +[$2,000 x (PVFA 12%, 5 years)] + [$(7,000) x (PVFA 12% 15 years – PVFA 12% 5 years)] NPV = $(150,000) + [$2,000 x 3.6048] + [$(7,000) x (6.8109 – 3.605)] NPV = $(150,000) + $7,210 + $(22,443) = $(165,233) Following is a different way to perform the same calculations for Alternative 2: NPV of installation cost $(150,000) NPV of annual maintenance cost $(10,000) x (1-30%) x 6.8109 (47,676) NPV of amortization tax shield $30,000 x 30% x 3.6048 32,443 Total NPV $(165,233) B. Following are the NPV calculations without the amortization tax shield: NPV without income taxes for Alternative 1: NPV of installation cost $(100,000) NPV of annual maintenance cost $(20,000) x 6.8109 (136,218) Total NPV $(236,218) NPV without income taxes for Alternative 2: NPV of installation cost $(150,000) NPV of annual maintenance cost $(10,000) x 6.8109 (68,109) Total NPV $(218,109) © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 44 The answer depends on management's time-frame used in the budget process. If the not- for-profit organization intends to occupy the building for the next 15 years, alternative 2 is still the best choice. However, management may concern itself only with current year outlays (a focus of many governmental units). In that case, alternative 1 might be chosen because its initial cost is $100,000 less than alternative 2's. Although this is a common approach, one might question whether it is "proper." 12.37 Equipment Replacement, NPV, IRR, and Payback - Garco A. Present Value Present Factor Value Initial net investment (1,000,000 - 60,000) 1.00 $ (940,000) Annual savings 300,000 3.6048 1,081,440 Net present value $ 141,440 B. First calculate the present value factor for an annuity of 5 payments that equates the cash inflows and outflows: $300,000 * F = 940,000 F = 3.13333 A factor of 3.13333 represents an internal rate of return of slightly less than 18%. A spreadsheet could be used to determine the exact answer of 17.913%. C. Assuming the cash flows take place evenly throughout the year: $940,000/$300,000 = 3.13 years © 2012 John Wiley and Sons Canada, Ltd. 45 Cost Management PROBLEMS 12.38 Capital Budgeting Methods, Sensitivity Analysis, Spreadsheet Development, Uncertainties - Jackson A. The choices are (1) hold the stock and work for $90,000 per year or (2) sell the stock, do not take the job, and start the restaurant. B. Either IRR or NPV methods could be used for this analysis. The decision is a long-term decision and therefore needs to include the time value of money. Both of these methods do that. With the NPV method, inflation rates for different categories of costs could be used, so the results would be more precise. In addition, it may be easier to understand the differences in these two plans in today’s dollars, rather than in rates of returns. C. His opportunity costs are $90,000 plus benefits from the job offer, plus the return on the stock. D. The following categories would be set into an input box: Investment amount, risk free rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates, all of the cash flows from the restaurant (revenues and variable and fixed costs). Once these are in the input box, formulas for calculating the incremental cash flows over time need to be set up, and the real cash flows would need to be inflated and then discounted. If amortization is relevant for the investment, a calculation would need to be included to account for the amortization tax shield using the appropriate CCA rate. E. Uncertainties about a new job include lack of information about the people Jackson would work with, and also about the nature of the work to be done. The future of the company is not guaranteed. Students may have thought of other uncertainties. F. Jackson faces uncertainties about customer preferences, which will result in uncertainty about revenues. He has not operated a restaurant, so he faces uncertainties about current costs and cost trends over time. He also faces uncertainties about the quality and quantity of employees available to cook, wait tables, and perform other tasks that need to be done. G. Jackson faces many uncertainties, no matter which alternative he chooses. If he performs sensitivity analyses around each alternative and formally incorporates qualitative factors, such as the amount of enjoyment he takes in his current position and his perceptions of this aspect of owning a restaurant, he will be able to make a high quality decision. © 2012 John Wiley and Sons Canada, Ltd. Chapter 12: Strategic Investment Decisions 46 12.39 NPV, Payback Methods, and ARR – TubeFab Inc. A. Net Present Value: PV Initial Investment: ($60,000)+($5,000)+$20,500 = $(44,500) Old New Incremental Annual Cash Flows: Machine Machine Inflow Factor Direct labour 13,500 7,900 5,600 Machinery costs 3,000 3,400 (400) Cleaning & setup 2,500 1,200 1,300 PVIFA (10,8%) Outflows 19,000 12,500 6,500 6.7101 43,616 PVIF (10, 8%) Terminal Value inflow 2000 4000 2000 0.4632 926 Working capital inflow 5,000 0.4632 2,316 NPV $2,358 B. Point of Indifference: (44,500) + 6.7101X + 926+2,316 = 0 6.7101X = 44,500-926-2,316 6.7101X = 41,258 X= $6,148.64 annual cost savings C. Payback Period: $44,500 / 6,500=6.85 year D. AARR: Amortization difference = 4,000 – 5,600 = - $1,600 (6,500-1,600) / 44,500 =11% E. Quantitative: 1. NPV >0 (go) 2. Payback Period > Cutoff period (no go). 3. Accounting Rate of Return > RRR (go) Qualitative: The management should consider if there is any impact on morale due to the layoff of personnel. Also, the quality of the product, efficiency of the production, and the lesser need for rework should also be considered. Yes, TubeFab Inc. should proceed with this investment:. © 2012 John Wiley and Sons Canada, Ltd. 47 Cost Management 12.40 IRR, Developing a Discount Rate, Evaluating Risk - Homeless Shelter A. Advantages of IRR • It is easy to explain • It can be calculated using a spreadsheet Disadvantages • Without spreadsheets, it is time consuming to calculate • It does not take into consideration the relative size of projects • It does not give information about the dollar value of the investment. B. The discount rate should be different for every project because the risk of every project is different. Part of the discount rate is the risk premium, and that should be higher for projects that are riskier. C. For discount rates, the following information would be helpful: current and historical inflation rates and T-bill rates. In addition, historical financial information about the three alternative projects or similar projects would be important to develop the risk premium. Information about demand for rooms, apartments, and boxes would be needed. Information about the availability of management and employees for the three alternatives would be useful. D. The answer to this question depends in part upon the assumptions made about the current operations of the homeless shelter. If the shelter’s current op
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