anthonyIM_27.doc

CHAPTER 27 LONGER-RUN DECISIONS: CAPITAL BUDGETING

Changes from Eleventh Edition

All changes to chapter 27 were minor. Approach

Capital investment decisions are a special kind of alternative choice problem. They are analyzed in the same way as that used for the problems described in Chapter 26 with the e!ception that the timing of cash inflows and outflows must be taken into account. This one difference is an important one however. "n order to incorporate its effect in the analysis one must have a thorough understanding of the concept of present value. #ecause of the difficulty difficulty that students students seem to have with with the topic the discussion discussion of present value in the first part of this chapter proceeds $uite slowly unless the Appendi! to Chapter % was previously assigned and discussed. &nce students understand the nature and use of this concept they should have relatively little difficulty with most other topics discussed in the chapter. 'uite early in the chapter the steps in analyzing a capital investment problem are set forth. As various aspects of the analysis are discussed it is a good idea to relate each of them to these steps and to keep the students continually aware of the purpose of the analysis namely to reach a decision on the acceptability of a proposed capital investment. The reason for the omission of depreciation is often difficult to understand. (tudents must appreciate that the procedure takes into account the recovery of the investment and that to include depreciation as a separate item of cost would be double counting. "n addition to the te!t discussion of this point it may be desira desirable ble to introd introduce uce additi additiona onall illust illustrat ration ions. s. "t may also also be desira desirable ble to relate relate this this topic topic to the corresponding discussion in Chapter 26. (tudents have difficulty in understanding the depreciation ta! shield. They learned in Chapter 26 that

#ccounting: $ext an% Cae &'e ( )ntructor* Manual

#nthony+Ha,kin+Merchant

Problems

Problem 27-1 Land Donated

Land Sold

Calculation of /et "ncome0 1reta! income before disposal..................................................................................................................................................... 3333333 3333333 Addition to +deduction from- ta!able income.............................................................................................................................. +33333333 1reta! income after disposal........................................................................................................................................................ 4%43333 33333 "ncome ta! 5 .3........................................................................................................................................................................  486333  3333 Accounting income before disposal............................................................................................................................................. 3333333 3333333 9ess book value of land............................................................................................................................................................... 3333 1lus gain on sale of land.............................................................................................................................................................. : 33333 1reta! accounting income............................................................................................................................................................ 4443333 333333 9ess income ta! +above-.............................................................................................................................................................. 486333 3333 /et "ncome................................................................................................................................................................................  63333  6386333 Calculation of cash flow (aving in ta! .3 ! 3333....................................................................................................................................................  333 Cash from sale.............................................................................................................................................................................  3333 9ess additional ta!....................................................................................................................................................................... : %%333 Additional cash............................................................................................................................................................................  333  22333 (trangely enough the company is better off to donate the land rather than to sell it. /otes0 +- "t would also be correct to calculate the additional ta! at a capital gains rate of say 28 percent. +2- The cost of the land is disregarded in the ta! calculation. Actually the ta!able gain would probably be 3333 * 3333 ; 33333. +-

B'--. McGra,/Hill+)r,in

Chapter '.

Problem 27-#: Corrine Compan!

a.

(99 &> >/T "f sell Cost.............................................................................................................................................................................. 273333 Accumulated depreciation............................................................................................................................................ %3333 +2733338 years- ! 3 years #ook value................................................................................................................................................................... 43333 (elling price................................................................................................................................................................. 228333 9ong*term gain............................................................................................................................................................ 8333 Ta! 5 .3..................................................................................................................................................................... 3833 /et gain after ta!.......................................................................................................................................................... 4833 /et cash inflow ; 228333 * 3833......................................................................................................................... %833 "f rent >ent proceeds per year................................................................................................................................................ 72333 =aintenance etc........................................................................................................................................................ 27333 ?epreciation................................................................................................................................................................ %333 8333 /et rent income before ta!.......................................................................................................................................... 27333 Ta! 5 .3.................................................................................................................................................................... 3%33 /et rent after ta!......................................................................................................................................................... 6233

b. The cash flow of 8333 * 3%33 or 233 after ta! for five years is 7333 which is less than the after*ta! profit from a sale now. +The present value of 233 for 8 years at say 3D is 24682 even less than the 7333 and more accurate making the sale even more attractive.- #ut the value of the warehouse 8 years hence is not mentioned. "t might be sold at a large enough gain to offset the difference between rent proceeds and a sale now. >ent might increase or e!penses increase. vidence is weighted in favor of a sale now for after*ta! benefits.



Problem 27-%: 'ellington Corporation

Calculation of 1ro,ect >eturns

Pro(ect  2   8 +a33333 33333 3333 23333 83.333

)sef*l Life 6 years  8 2  28333 ÷ 3333 ÷ 8333 ÷ 3333 ÷ 2833 ÷

+nvestment, +nflo .a/ .3 . %.3 2.3 .3 ; .3 ; . ; %.3 ; 2.3 ; .3

et*rn .b/ D %D 4D 3D negative

an0 st rd 2nd th 8th

+b- >eturns for 1ro,ects * are from Table #. 1ro,ect Es return is zero since the nondiscounted inflows +3333 ! 2- e!actly e$ual the initial investment. 1ro,ect 8 over its entire life returns only 7833 of the initial 83333 investment so its return must be negative. Problem 27-: a3ton Compan!

a. ?ifferential after*ta! cash flows +333 omitted-0 1445 1441 1442 (ales.............................................................................................................................................................................................. 333 633 %33 =aterial labor direct overhead..................................................................................................................................................... 33 783 83 Added rent +2833 ! -.............................................................................................................................................................. 83 83 83 ?epreciation.................................................................................................................................................................................. 83 33 83


c.

Chapter '.

443 /et income............................................................................................................................  833 44 /et income............................................................................................................................ 22833 442 /et income............................................................................................................................ 36833 82833 Average income............................................................................................................................. 7833 +Average investmentF...................................................................................................................... 83333 +2Accounting rate of return............................................................................................................... 22D +÷2Average "nvestment /et ?epreciation 433 +.6- ;  83 Cash outlay for e$uipment ; 3%3 623 ;  83

d. The pro,ect should be adopted if a 23D after*ta! rate of return is re$uired0 Present val*e of cash flos at 256: 4430 83333 ! 3.% ;  2%3 440 633333 ! 3.64 ; 633 4420 %3333 ! 3.874 ; 277423 483

The present value of 483 is greater than the initial outlay of 3%3333) therefore the pro,ect more than satisfies the 23D re$uirement. e. "f the student does not have access to a calculator or computer programmed to make ">> calculations the ">> must be estimated using a trial*and*error approach. The ">> is slightly in e!cess of 22D as shown by these calculations0 "ear 4430 440 442

Cash lo 83333 633333 %3 333

226 actor 3.%23 3.672 3 88

226 P898  %233 3233 26 %3

2$6 actor 3.%36 3.683 3 82

2$6 P898  363 43333 28 823



There are several valid ways in which the figures may be put together. There are also several ways of arriving at the basic figures for investment and earnings. This may lead to confusion when students come to class with solutions prepared in accordance with different methods. &ne way of avoiding this is to specify a method when assigning the case. Ge prefer to let the students use whatever method they wish and e!pect them to be able to follow someone elseEs method as it unfolds in class. &ften after someone has started the class discussion with a valid method we ask everyone to continue to develop the data in accordance with that method and although they do not like to make the adaptation they usually can do it. The commentaries to several of the cases are more detailed than students reasonably can be e!pected to develop in class. Case 27-1: Sinclair Company ote: $hi cae i unchange% from the Ele!enth E%ition . Approach

These problems are constructed so that each one builds on the preceding one and brings out a new point. "t often happens that in connection with the very first problem students raise $uestions that range all over the chapter. " ask them not to do this as the $uestions usually can be handled better later on in connection with the specific problems to which they apply. Also " prefer to get right to the problems rather than spending very much time on the te!t. " do go over the idea of present value and answer some $uestions but " think troublesome points are best handled in the conte!t of specific problems. "n introducing 1art A " may ask0 H"f you were going to buy a machine and had your choice of paying 8 now or  a year for the ne!t five years which would you takeIJ /e!t H"f you had your choice of paying 8 now or  per year for si! yearsIJ H

.

Chapter '.

"nvestment.............................................................................................................................................................. 283333 Annual earnings..................................................................................................................................................... 7833 1resent value 3 years 8D0 7833 F 8.34........................................................................................................ %%2 ?ecision0 /et present value ; *67%7) therefore................................................................................................... ?o not purchase

Moral 0 Although total earnings are appro!imately the same as in $uestion  +78333 versus 63333- the present value is considerably different. "t is the pattern of earnings through time that counts not the total Hamount.J PA&  . "nvestment.............................................................................................................................................................. 833333 Annual earnings..................................................................................................................................................... 63333 1resent value0 63333 F .82.............................................................................................................................. 8623 ?ecision0 /et present value ; 623) therefore.................................................................................................... 1urchase +"f =odel A has resale value the return would be even higher.2. The error arose when =odel A was purchased. Assuming the situation in A+- =odel A has an acceptable return if its economic life is 8 years. "t turns out that its economic life was only two years) conse$uently =odel A should not have been bought +although this is known only from hindsight-.

Moral 0 ?onEt let past mistakes prevent you from making wise decisions now +i.e. sunk costs are irrelevant-. PA& C

The 4% Ta! Act +and subse$uent acts- with AC>( provisions usually makes this kind of a computational nightmare for students because of the erratic HdepreciationJ +officially Hcost recoveryJamounts in years *8 and the absence of such amounts in later years. Ge have assumed that the AC>( allowances stay at 8D 26D 8D 2D 2D for 8*year assets. The cash flow pattern including a 8D +assumed to be time zero- "TC is0 1K of cash savings of 63333year for 8 years ; 63333 F .63 F .44............................................................. %2%


.


PA& D "nvestment............................................................................................................................................................................. 283333 1resent value of earnings Lears *0 74833 F 2.2% +Table #-............................................................................................................................... %44 Lears *80 63783 F .364F............................................................................................................................................. 642 Total 1K of earnings..................................................................................................................................................... 26

?ecision0 ?o not purchase since /1K ; * 884. FThis is the difference between .82 and 2.2%

2. Although the total earnings for the 8*year period are the same in 1art ? as in A+- shifting more of the earnings to the early years and less to the later years increases the present value from 2 to 26. Moral 0 The time pattern of earnings makes a difference.

.

"nvestment net of "TC.......................................................................................................................................................... 27833 1resent value of cash savings0 Lears *0 74833 F .63 + * ta! rate- F 2.877................................................................................................................. 2242 Lears *80 63783 F .63 F l.6...................................................................................................................................... 86 1resent value of AC>( depredation ta! shield0 23%4%8 F .3................................................................................................................................................................. %84 Total present value................................................................................................................................................................ 28%3 F.44 +8 yrs.- N 2.877 + yrs.-

Moral 0 The combination of ta!*shield benefits and a shift in earnings now makes the decision to purchase a good one +even without the 2833 "TC-. Case 27-2: Rock Creek Golf Club* ote: $hi cae i unchange% from the Ele!enth E%ition .


2   8 8 3 *8

Chapter '.

?epreciation ta! shield....................................................................................................................................... 7372 n.a. ?epreciation ta! shield....................................................................................................................................... 2 n.a. ?epreciation ta! shield....................................................................................................................................... %2 n.a. ?epreciation ta! shield....................................................................................................................................... %2 n.a. 1roceeds from disposal....................................................................................................................................... 4633 n.a. Time Pero flow.................................................................................................................................................... %23 82%3 /1K of net streams.............................................................................................................................................. 82F 82F .44 ; 7734% .44; 243

ate...................................................................................................................................... 7788 4 >&ES &> E<=++& A:

F"tems so marked can be eliminated from the analysis because they are the same for either alternative and because not ac$uiring the new carts has been e!cluded by the case as an alternative. . 233 F 3 carts F . ta! rate 2. %333 F + * .. 23 F 3 carts F + * .. 833 F 3 carts F + * .-



ote0 $hi cae i unchange% from the Ele!enth E%ition0 S!nopsis 1huket #each Rotel has an opportunity to lease its under*utilised space to a karaoke pub and earn a rental income. Alternatively the hotel could develop the unused space and create its own pub. The general manager of the hotel must decide which of the two capital pro,ects to recommend to the hotel owners. The case presents sufficient information to build cashflow forecasts for each pro,ect and to rank the mutually e!clusive pro,ects using various evaluation criteria. &eaching >b(ectives

This case may be used to e!pose students to a range of capital*budgeting i ssues0 •

The principle of incremental analysis for identifying relevant cashflows for a pro,ect.

•

The treatment of sunk costs corporate overhead allocations opportunity costs e!ternalities and social costs in the identification of relevant cashflows.

•

The use of ?C< versus non*?C< techni$ues i n evaluating capital budgeting pro,ects.

•

1ossible conflict in pro,ect rankings on the basis of /1K and ">>.

•

The use of the e$uivalent*annuity criterion to solve the problem in ranking pro,ects of une$ual life.

•

"dentification of Hkey value driversJ for performing sensitivity analysis.

S*ggested ;*estions

.

1lease assess the economic benefits associated with each of the capital pro,ects. Ghat is the initial outlayI Ghat are the incremental cashflows over the life of the pro,ectI Ghat is an appropriate discount rate to use for discounting the cashflows of the pro,ectsI


Chapter '.

occurs as a direct result of accepting t he pro,ects. They include changes in e!isting revenues e!penses and ta!es caused by a pro,ectEs acceptance. The financial controller in this case stresses the importance of identifying future profits instead of cashflows. (tudents should note that accounting profits are not the relevant measure of benefits. )gnore unk cot

A sunk cost is an outlay that has already been committed or that has already occurred hence is not affected by the decision under consideration. "n this case t he overhead e!penses and salary e!penses of the e!cess labour can be considered as sunk costs. /ote that repairs and maintenance e!penses will increase if the karaoke pro,ects are accepted. "n this situation it is appropriate to include such incremental e!penses in the cashflow estimates for both pro,ects. Coni%er externalitie

!ternalities represent the effects of a pro,ect on other parts of the firm. "n this case the possible reduction in room sales should be considered in the analysis for both pro,ects. The social effects of the pro,ects are difficult to $uantify) yet they should be taken into account if the detrimental effect on the hotel will affect the pro,ectsE future cashflows. Coni%er opportunity cot

&pportunity costs are cashflows that could be generated from an asset the firm already owns provided it is not used for the pro,ect in $uestion. #ecause the two pro,ects in this case are mutually e!clusive the opportunity costs of one pro,ect are the cashflows that are forgone due to the re,ection of the other pro,ect. Pro(ect Eval*ation &echni?*es

"n this case since it is technically impossible for the hotel to undertake both pro,ects on the same site the acceptance of one pro,ect implies the re,ection of the other. Thus the two pro,ects are mutually e!clusive and a ranking of the two pro,ects in terms of their economic attractiveness becomes necessary. The present capital budgeting system in 1huket #each Rotel ranks pro,ects according to payback period and average return on investment. Although these methods are simple to use they have a number of weaknesses that dis$ualify them as effective methods for ranking pro,ects. "n fact there are other pro,ect evaluation techni$ues that are more effective. The following table summarises the advantages and disadvantages of each of the pro,ect evaluation techni$ues.



/ote0 The discounted payback method is similar to the regular payback method e!cept that it discounts cashflows at the pro,ectsE cost of capital. "t considers the time value of money but it ignores cashflows occurring after the payback period. ))

iscounte, Cashflo .echni/ues 0c )nternal rate of return 0)RR Advantages

Disadvantages

−

Takes into account the time value of money

−

1ossible e!istence of multiple ">>s

−

"s in general consistent with the firm goal of shareholder wealth ma!imisation

−

>e$uires more complicated calculations

−

>e$uires detailed long*term forecast of incremental costs and benefits

−

"mplicitly assumes that the intermediate cashflows from the pro,ect are reinvested at the ">> rather than at the opportunity cost of capital

0, Profitability )n,e& 0P) Advantages −

"s consistent with the firm goal of shareholder wealth ma!imisation

−

Takes into account the time value of money and the scale of investment

Disadvantages −

>e$uires detailed long*term forecast of incremental costs and benefits


Chapter '.

S*mmar! of es*lts

ption Planet @arao0e P*b

*ild >ption each @arao0e P*b

Pa!bac0

2.6 years

.% years

Disco*nted pa!bac0

.3 years

.48 years

Average ret*rn on investment

4D

3D

+

2D

7D

P+

.2

.22

P9

6837 baht

73 baht

E?*ivalent ann*it! .EA/

82436 baht

%788 baht

The above summary shows that ranking conflicts have arisen. The first four measures favour the lease option while the 1" and /1K measures favour the build option. The last measure e$uivalent annuity which solves the une$ual life problem also favours the buil d option. +1lease refer to the earlier e!hibit on the pros and cons of using each measure.The graph below illustrates the classic Hcross*overJ problem in which conflict in pro,ect rankings arises on the basis of the /1K and ">> criteria. The standard approach to this problem is to rely on the ranking by /1K because the implicit reinvestment*rate assumption in the /1K method is more reasonable than that in the ">> method. +P" Profiles of the 4ease an, uil, 5ption

The graph shows that the /1K profiles of the two pro,ects cross over when the discount rate used is 6D. The ranking conflict between /1K and ">> disappears at discount rates above 6D. /ote that the build optionEs net present value profile has the steeper slope indicating that a given change in discount rate has a larger effect on its net present value. The build option has a greater sensitivity because it offers rising cashflows in the later years. "ts



58% .base/

9'7-;

<.79=9

Buil%

587%

+88266-

+843-

>e,ect both

1

+8%%-

+877-

>e,ect both

Sensiti'ity nalysis: upfront in'estment 6 increase in *pfront investment

Lease >ption EA .baht/

*ild >ption EA .baht/

Decision

56 .base/

9'7-;

<.79=9

Buil%

%6

83

876%3

#uild

156

44

27%6

9ease

256

83%2

+42-

9ease

#56

+%3-

+46-

>e,ect both

Sensiti'ity nalysis: cost of capital Cost of capital

Lease >ption EA .baht/

*ild >ption EA .baht/

Decision

6

66676

22887

#uild

1587%6 .base/

9'7-;

<.79=9

Buil%

126

686

72

#uild

1$6

6237

8322

#uild

16

2872

%27

9ease

16

8387

+%%%4-

9ease


Chapter '.

.he 4ease 5ption Cost of capital Patronage actor

6

1587%6

126

1$6

16

16

5

274224

26483

2864

288

23

22286

582%

672482

68%2%

6872

63%64

624%62

6%736

58%

66676

82436

686

6237

2872

8387

587%

+8463-

+88266-

+88%68-

+86%88-

+87%7-

+8%%842-

1

+8%77-

+8%%-

+6%%-

+77-

+%28%7-

+422-

ifference in %/ui'alent nnuity 0in baht uil, - 4ease8 Cost of capital Patronage actor

6

1587%6

126

1$6

16

16

5

437

6%%6

8742

3%63

28

8474

582%

784

8862

6%

2%7

%3%

+%4%-

58%

88%%

64

2746

%%8

+7%-

+246-

587%

%6%

778

%22

+723%-

+2242-

+%434-

1

2388

74

+%8-

+22-

+%34-

+8%7-

E<=++& &-1 &=E LEASE >P&+>: PLAE& @AA>@E P) AAL"S+S > >PEA&+ CAS=L>'



+
5

1

2

#

$

/et room revenueF

233333

6333

7333

%333

>eduction in net room revenue

683333

6%333

76728

%88833

1

2

#

$

>ental income

233333

233333

22333

22333

9ess0 ?epreciation e!pense

+42833-

+42833-

+42833-

+42833-

"ncrease in repairs U maintenance

+3333-

+3333-

+3333-

+3333-


+683333-

+6%333-

+76728-

+%88833-

Additional operating income

%7833

8833

7278

%333

9ess0 ta!es

+86283-

+683-

+87-

+28233-

/&1AT

283

3%83

2366

8%%33

Add0 ?epreciation

42833

42833

42833

42833

"ear

5

9ess0 Capital e!penditure

+773333-

&perating cashflow

+773333-

2783

33683

6

2833

?iscounted operating cashflow

+773333-

24228

287

2386

6734

1ote: &0 #!

n on in!etment i calculate% a the a!erage of the cahflo, o!er the life of the pro"ect


Chapter '.

E<=++& &-2 &=E )+LD >P&+>: EAC= @AA>@E P) AAL"S+S > >PEA&+ CAS=L>'

1ro,ect life

6 years

Qpfront investment * renovation

%33333 baht

* e$uipment

433333 baht

Ta! rate

3D

cost of capital

3.78D

(ales growth rate

8D

28D of sales

(alary

6D of sales

&ther operating e!pense

22D of sales

"ncrease in repairs and maintenance

3333 baht

Annual capital e!penditure

e$uals depreciation

1atronage factor

3.8

1atronage factor

?ecrease in net room revenue

3

3D

3.28

6.28D

38

2 83D

+
"ear

5

1

2

#

$

%



/et room revenue

233333

6333

7333

%333

83333

8333


683333

6%333

76728

%88833

%42833

4378

"ear

5

1

2

#

$

%



(ales

672333

438633

883%%3

83%2

867%%8

84627%7

9ess0
+6%333-

+22633-

+2%7723-

+8236-

+47-

+43647-

&ther operating e!penses

+327%3-

+37422-

+4-

+%4%8-

+246-

+%-

"ncrease in repairs and maintenance

+3333-

+3333-

+3333-

+3333-

+3333-

+3333-

?epreciation

+2%-

+2%-

+2%-

+2%-

+2%-

+2%-


+683333-

+6%333-

+76728-

+%88833-

+%42833-

+4378-

Additional operating income

82%27

6268

66483%

776

%2488

46864

9ess0 ta!es

+84%%-

+%7343-

+233%82-

+282%4-

+27%6-

+2%347-

/&1AT

72474

68

6%686

8322

87676%

68884%

Add0 ?epreciation

9ess0 Capital e!penditure

2%

2%

2%

2%

2%

2%

6862

74%7%

784%4

7%8678

%6332

4%42

+2%-

+2%-

+2%-

+2%-

+2%-

+2%-

Qpfront investment

+733333-

*

*

*

*

*

*

&perating cashflow

+733333-

72474

68

6%686

8322

87676%

68884%

?iscounted operating cashflow

+733333-

6778

884

833

436

668

882%

Pa!bac0

.% Lears

Disco*nted pa!bac0

.48 Lears

Average ret*rn on investment

3D

+

7D

Profitabilit! +nde3

.22

P9

73 #aht

EA

%788 #aht

anthonyIM_27.doc

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