Capital Budgeting Teaching Notes For Cases

Chapter 20
Capital Budgeting
Teaching Notes for Cases
20-1 The Case of the Almost Identical Twins (Source: George J. Staubus, The Case of the
Almost Identical Twins, Issues in Accounting Education (Spring 1993), 8 (1), pp. 187-190.
The objective of this case is to compare Spenders and Savers financial situations over their lives, with
emphasis on the later years. In making that comparison, students will gain some experience in compound
interest calculations and some insight into the most basic personal financial decision: the division of
income between consumption and investment.
I see three particular values in the case. The most obvious is that it is an exercise in discounting and
compounding, with a wide range of difficulty. Second, the case requires the student to use some initiative
in computing and data processing. To gain this value, I give the students no advice beyond that in
requirement 1(d). After the work is done, those who used a spreadsheet approach, as well as those who did
not, see the value of spreadsheet skills. Finally, the consequences of high school students spending-saving
behavior is a dramatic lesson: saving while in high school grows to a paid-for home plus $1,000,000 and a
six-figure annual income at age 54.
I give my students the choice of working independently or in teams that they organize as they wish. I
assign the case when they are studying discounting and compounding and give them a week to do it.
Requirement 1(a): Monthly earning carried forward for 48 periods at 2/3 at 1%. Result: $11,021.
Requirement 1(b): Senders car payments to pay off $11,021 in 48 periods at 1.5% = $323.74 per month.
Savers accumulated savings from depositing $323.74 per month earning 2/3 of 1% amount to $18,243,
his down payment on the house. Purchase price of the house is $91,215; mortgage is $72,972.
Requirement 1(c): Monthly payments on $72,972 for 30 years at 10/12% per month are approximately
$640.
Requirement 1(d): I have found no easy way to make the computations required here. Whether they are
done by computer or by the old-fashioned way, one might use column headings along the following lines:
(1)
(2)
(3)
(4)
Year
n
Savers
Monthly
Mtg. Pmt.
Spenders
Monthly
Rent
(3) - (2) =
Monthly
Saving
Blocher, Stout, Cokins, Chen: Cost Management, 4e
(5)
(4) x
A12, 0.0067 =
Year-end
Transfer to
Mtg. Fund
20-1
(6)
(7)
an,i*
(5) x (6) =
Value, End of
Year 30
The McGraw-Hill Companies, Inc., 2008
1
2
.
.
$640.37
$640.37
.
.
$640.37
$672.39
.
.
0
32.02
.
.
$ 0
398.63
.
.
17.9570
16.2550
.
.
0
6,479.91
.
.
an,i = 1.008(30 - n)12
In one algebraic statement, at age 52, Saver has:
30
{[1,640(1.05) 640]( 1.0 67 1)/0.0 67)(1.0 83

n1
12
12(30n)
)} $826,621
n1
At age 54, Saver has $826,621 x 1.008324 $1,000,212.
Requirement 1(e): Annual income: $1,000,212 x 0.0083 x 12 = $100,021, or, $1,000,12x 0.10.
Requirement 2: Spender consumed more during the four-year high school period; the two lived at the
same level during college and until Saver burned his mortgage. For the next two years, Saver consumed
more by the amount of Spenders rent. After age 54, Saver was retired on an annual income of $100,021,
while Spender presumably continued to work. Saver was able to leave $1,000,000 plus a residential
property. My students have not always seen these differences clearly. For example, several have said that
Saver spent less all of his life. Naturally, one must take care to avoid implying that Saver was a better
person in any sense other than financially. Spender may have had more fun.
Requirement 3: This should be a wide-open discussion. Note that the terms of the case have Spender and
Saver absorbing property taxes and insurance on similar homes, but students may think of differences in
other areas, such as maintenance. Over the course of 1991 and 1992, the interest rates given in the case
have become somewhat unrealistic, but who knows what will be realistic next year? Relatively advanced
accounting students certainly should think of income-tax aspects and the impact of inflation on the
comparability of the numbers. The case can be worthwhile for students at various levels, especially if the
last part of Requirement 3 is taken seriously.
20-2
20-2: ACE Company (A) (Source: Chee W. Chow, Y. Hwang, and D. F. Togo, Ace Company: A
Case for Incorporating Competitive Considerations into the Teaching of Capital
Budgeting, Issues in Accounting Education, Fall 1995, 10 (2), pp. 389-401.
Abstract: Accounting education is increasingly focused on developing students ability to structure and
analyze complex problems and to adopt a managerial/strategical approach to issues. To support this
change, course materials must be developed that emphasize the new focus.
This hypothetical case uses the development of a new product to introduce a strategic dimension to the
teaching of capital budgeting. Students are led to consider factors that include the cannibalization of an
existing profitable product and the deterrence of competitors entry into the market. The case analysis
begins with a simple NPV analysis of the decision without considering the potential effects on
competitors actions. Then it progresses to increasing layers of complexity, which introduce the strategic
aspects of the decision. This process solidifies students mastery of capital budgeting methods. It also
helps them to appreciate that effective management requires going beyond the learning of techniques to
consider the larger, competitive context.
The myopic use of DCF techniques and lack of strategic considerations in capital investment analysis have
been suggested as obstacles to many companies attempts at innovation (Aron and Lazear 1990; Foster
1986; Hodder and Riggs 1985; Kaplan 1986; Pinches 1982). This case helps to develop student
understanding of the importance of strategic considerations in capital budgeting decisions, as well as how
to incorporate such considerations into the analysis.
We typically seek active student participation throughout the case discussion. When used in this way, the
case requires a 100-minute session. The case can be covered in a 50-minute session by taking a more
directive approach, especially in addressing the second question.
We suggest taking the two assignment questions in sequence. Question one is straightforward and can be
answered rather quickly. It helps to ensure that the students understand the case facts and are able to
perform a NPV analysis. The first solution also establishes a base of comparison for results of the second
question.
To promote participation, the instructor can enlist student assistance in constructing a table similar to
Table 1. This table shows the NPV computations for the status quo as well as the one-year and two-year
plans. Both Model Z introduction plans have substantially higher NPVs than the status quo. The two-year
plans NPV exceeds that of the one-year plan by $98.355 million ($1,042.965 vs. $944.61 million). Based
on these comparisons, the class will support the two-year plan.
Next, students can be asked how the analysis should be changed to take into account the potential entrance
of a competing product.1 The case is very explicit that ACEs major competitor is able to enter the market
at the end of Year 2. Hence, students will recognize that ACEs net cash flows from each alternative would
depend on whether the competitor selects this option.
Some students may have difficulty following the increased complexity. We recommend developing a
decision tree like Figure 1 to provide structure to the analysis. Depending on the students prior exposure
1 We typically give out assignment question 2 as it is stated, without any guidance on how it should be approached.
This approach is based on the belief that students can benefit significantly from having to come up with and evaluate
ways to organize the relevant case facts. We typically ask several students to present their approaches to this
assignment and have the rest of the class critique them. Instructors who prefer more directive approaches can append
to question 2 the suggestion that the students prepare a decision tree.
20-3
to decision-making under uncertainty, the instructor may want to vary the extent to which the analysis is
developed interactively vs. in a directive or even lecture format.
Figure 1 shows that with the potential entry of a competing product, each of ACEs three alternatives has
two possible outcomes. The analysis in Table 1 is thus incomplete because it has excluded outcomes 1, 3,
and 5.
Before addressing the three newly added outcomes, it is useful to show that the terminal values for
outcomes 2, 4, and 6 have already been computed. These are the three NPVs from Table 1 and can be
entered into Figure 1. (Figure 2 is provided to show Figure 1s evolution as terminal values are added.
Constructing an entirely new diagram is unnecessary during class discussion.) With this discussion,
students will realize that the logical next step is to develop ACEs expected cash flows and NPVs for the
added outcomes.
Table 2 provides the annual cash flows and NPVs for the three added outcomes. Because the annual cash
flow amounts are less straightforward than those in Table 1, it is desirable to develop them in some detail.
A benefit of this process is that it can increase student understanding of the way in which competitive
forces might affect the outcome of a decision.
Panel A of Table 2 shows that even if ACE does not introduce Model Z, it still cannot count on Model Xs
net cash inflows remaining intact in its remaining market life. Compared to Panel A of Table 1, Model Xs
net cash inflow in Year 3 is lower by $100 million due to the competitors entrance at the end of Year 2.
Panel B of Table 2, on the other hand, is identical to the corresponding panel in Table 1. This is based on
the assumption that even if the competitor were to enter the market at the end of Year 2, Model Z still
would have an overwhelming first-mover advantage from having been introduced one year earlier. This
assumption is consistent with the case facts given under Other Considerations, and is aimed at
simplifying the numerical aspects of the case. If the instructor or students feel that this assumption is too
extreme, they can easily replace Model Zs cash flows in Panel B with numbers that they consider to be
more realistic.
Finally, Panel C of Table 2 shows that Model Zs net cash inflows in Years 3, 4, and 5 are only half of
those in Panel C of Table 1. This reduction reflects the expectation that Model Z and the competing
product would each get half of the market, since they would be introduced simultaneously.
Having completed Figure 2, the focus can shift back to choosing among the alternatives. The NPVs clearly
show that introducing Model Z at the end of Year 1 dominates the status quo ($944.61 for sure vs. either
$686.69 or $761.82). Less clear, however, is whether it is superior to the two-year plan. The latter does
have a lower NPV ($721.645 vs. $944.61) if the competitor were to introduce a comparable product
simultaneously with Model Z. But, its NPV is higher ($1,042.965 vs. $944.61) if Model Zs introduction is
uncontested.
This walk-through of Figure 2 should help students to appreciate that in a competitive environment,
effective decision making does not end with the calculation of some numbers like profits or NPVs. Rather,
what numbers are applicable depends on many factors, such as competitor decisions and actions, which
often are noncontrollable and unknown to the decision maker. Because of these factors, ACEs choice
between the one-year and two-year plans can be viewed as one between a (relatively) certain outcome and
a gamble.
To enhance internalization of this important point, the instructor may let students suggest how ACE might
go about making the decision. A range of suggestions will likely be offered, such as comparing the worst
and/or best outcomes under each alternative, comparing expected NPVs across alternatives, etc. While the
20-4
analysis can proceed with any of the suggested approaches, we recommend that the instructor propose
using expected value as the decision criterion, so as to keep the numerical computations from
overwhelming the students. Another consideration at this point is how much of the subsequent analysis to
develop interactively vs. in a directive or even lecture format. We recommend shifting to a more directive
approach (What numbers do we need to compute expected values?) at this juncture unless the students
have a uniformly strong background in decision-making under uncertainty. With the decision tree
providing a structure for identifying the relevant pieces of information and where they fit, students seldom
have difficulty following the evolvement past this point.
Computing expected values requires value for probabilities. Under the two-year plan, the probability of
ACEs major competitor introducing a comparable product simultaneously can be labeled p; thus, the
probability that it will not enter the market is (1 - p). Using these labels, the two-year plans expected NPV
can be represented as ($721.645 x p) + {$1,042.965 x (1 - p)}. Since the one-year plan involves no
uncertainty, its expected NPV is simply $944.61. The instructor can show that because p is the relative
weight of the two-year plans less profitable outcome, the higher the value of p, the smaller this plans
expected NPV would be. Thus, which plan has a higher expected NPV depends on the value of p.
At this point, the focus can shift to how ACE might estimate the values of p and (1 - p). A variety of
approaches can be suggested, including reverse engineering to understand the competitors cost structure,
reading trade journals, reading the competitors financial reports to gain insights into its plans, financial
strength, and problems.2 The students will readily see that this analytical process is a challenging one that
involves missing information and much subjective judgment and that, ultimately, the various pieces of
information still have to be combined in some way to yield point estimates of p (hence also that of its
complement, (1 - p)), and that it is unlikely these parameters can be estimated with precision.
With this discussion as background, the potential usefulness of a sensitivity analysis can be easily
established. This analysis can be introduced by suggesting that since it is difficult to precisely estimate the
value of p, it would help to simplify the task to one of placing p within some range. For ACEs decision
problem, the key number for defining this range is the break-even value of p, which would make the
expected NPVs of the one- and two-year plans equal. This value is obtained by solving the following
equation:
$944.61 = {$721.645 x p} + {$1,042.295 x (1 - p)}
The break-even value of p is ($1,042.965 - $944.61)/($1,042.965 - $721,645) = $98.355/$321.32 =
0.3061. If there is less than a 30.61 percent probability that ACEs major competitor would introduce a
competing product at the end of Year 2, then ACE would maximize expected NPV by choosing the twoyear over the one-year plan, and vice versa. Thus, ACE can focus on ascertaining whether p is likely above
or below 0.3061, rather than the much more difficult task of generating a precise point estimate.
All of the preceding computations and analyses can be done with the information already contained in the
case. It is possible to conclude the discussion at this point by reviewing the evolution of the analysis,
placing particular emphasis on the importance of viewing ones own decisions in the larger competitive
context. There remain, however, considerable benefits from pushing the analysis to yet a higher level of
2 Readings from the business press can increase student appreciation of the importance, nature, and difficulty of this
task. Jones (1988) describes how Caterpillar, a well-known company, analyzes competitors costs. This article lists
the major sources of information that Caterpillar consults. It also discusses the difficulties, and the role of subjective
judgments, in such analyses, as well as the need to apply multiple approaches to enhance the quality of estimates. A
Wall Street Journal article by Johnson (1987) also is of interest. It describes a real-world case of industrial espionage
aimed at gathering intelligence on competitors cost structures. Main (1992) can be used to extend the discussion to
benchmarking practices.
20-5
sophistication. Transition to this level can be accomplished by asking: If you were ACEs major
competitor, how would you analyze the options open to you?
The competitors analysis is very much a mirror image of ACEs analysis, and can be developed rather
quickly. The required data in this case are the competitors cost structure and its assessment of market
conditions. Since these data are not included in the case, one option is to let students suggest them. A
drawback of doing so is that it can increase the numerical complexity of the analysis. We recommend
asking students to assume that the competitor shares ACEs belief about the market (e.g., total size of
Model Zs potential market, the nature of the first-mover advantage, market shares of simultaneously
introduced competing products). We also would assume that the competitor can develop its version of
Model Z at a cost comparable to ACEs two-year plan. 3
Table 3 presents the competitors predicted cash flows and NPVs from introducing a competing product at
the end of Year 2 (the earliest it is able to do so) depending on whether ACE develops Model Z and if it
does, whether it adopts the one- or two-year plan. 4
Panel A of Table 3 shows that if ACE does not develop Model Z, then after investing $150 million in each
of years 1 and 2, the competitor would reap the net cash inflows that would otherwise have gone to Model
Z (including the $100 million captured from ACEs Model X in Year 3). Panel B assumes that if the
competitor invests $150 million in Year 1, and then finds ACE introducing Model Z at the end of Year 1, it
would abandon the project, since ACE would garner an insurmountable first-mover advantage.
Developing the figures for this panel affords the opportunity to discuss the irrelevance of sunk costs. 5
Panel C assumes that the competitor and ACE would each gain a 50% market share by introducing
comparable products simultaneously.6
Figure 3 presents a decision tree from the competitors perspective. It shows that product development has
a positive NPV if ACE either does not develop Model Z or it does so over two years. Overall, the
competitors expected NPV from product development would depend on its assessment of the probability
that ACE would select each of its three options.
At this point, the focus of the discussion can shift back to ACE. Students can be asked what action
implications the preceding analysis has for ACE. One implication is that if ACE adopts the two-year plan,
then it is quite likely (that is, p exceeds 0.3061) that Model Z would be faced with the simultaneous
entrance of a competing product. Table 2 shows that under this circumstance, the two-year plan still would
yield a positive NPV ($721.645 million), but it would be substantially below that expected from the oneyear plan ($944.61 million).
3 Recall from the case narrative that ACEs major competitor is assumed to be technologically less advanced. Thus,
using ACEs cost structure can be viewed as a best-case scenario from the competitors perspective.
4 The competitors NPVs are based on a 10% discount rate, the same as ACEs cost of capital. A different rate can be
easily used if the instructor believes that due to differences in size, market position, etc., it is more realistic to ascribe
to the competitors cost of capital.
5 All panels of Table 3 place the competitor at the current point in time, the same as ACE. Panel B assumes that
when the competitor makes the $150 million investment in Year 1, it does not know whether ACE would develop
Model Z. If it learns at the end of Year 1 that Model Z was entering the market at that time, then it initial $150
million would become a sunk cost. If the competitor persists by investing an additional $150 million in Year 2, it
would only increase its loss since the second-mover is assumed to gain only an insignificant market share.
6 In the process of developing Panel C, sunk cost issues also can be discussed. If the competitor discovers at the end
of Year 1 that ACE is embarked on a two-year development program, then its own $150 million Year 1 expenditure
becomes a sunk cost. The additional $150 million investment in Year 2 becomes the only incremental investment to
be weighed against the expected net cash inflows from Years 3, 4, and 5. The figures in Panel C clearly show that in
this case, it is profitable for the competitor to continue product development.
20-6
Does this mean that ACE should choose the one-year plan? Perhaps, but it would be even more profitable
to ACE (NPV = $1,042.965 million) if it could adopt the two-year plan and yet not face a competing
product. Since the competitors decision depends on its assessment of ACEs intentions, ACE can benefit
from actions that influence the competitors beliefs. For example, if ACE consistently adopted a policy of
rapid development and introduction of new products, even at the expense of cannibalizing its own
currently profitable products, it could establish a reputation for an aggressive product-development
approach. This reputation could help deter competitor entrance such that ACE may be able to
(occasionally) undertake stretched-out product-development programs without fear of being preempted.
The business press contains many reports of companies that use this approach to deter competitor entry.
For example, a Wall Street Journal article (Torres 1992) gave Intels slashing of prices on its 386
microchip, undercutting clone chip makers, and then rolling out the new generation of 486 microchips in
an extremely short period of time as an example of how a company can, at the cost of cannibalizing one of
its own currently profitable products, effectively deter competition and enhance market dominance.
Similarly, an article in Fortune (Deutschman 1994) described how Hewlett-Packard cannibalizes its
winning products by bringing out better, cheaper technologies ahead of its competitors. By means of
examples like these, the instructor can significantly increase student appreciation of the strategic aspects of
real-world managerial decisions.
Summary: Given the many layers of the analysis, it is desirable to close by systematically reviewing the
key points of the discussion. The major lesson to emphasize is that managerial decision-making does not
occur in a vacuum. Rather, the outcomes of actions depend on many factors external to the organization,
including the actions and countermeasures of competitors. Thus, effective decision-making requires more
than just mastering analytical techniques such as DCF. Rather, it demands explicit attention to the effects
of these outside forces and developing innovative responses to them.
20-7
FIGURE 1
Decision-Tree Representation of Potential Outcomes to ACE under Each Alternative
Competitor introduces
1 comparable product
No entry by competitor
3 comparable product
4 No entry by competitor
5
comparable product
6 No entry by competitor
20-8
FIGURE 2
NPVs of Potential Outcomes to ACE under Each Alternative
comparable product
Status quo: Model

X only
$686.69
$761.82
comparable product
$944.61
Introduce Model
Z, end of Year 1
4
Introduce Model
Z, end of Year 2
comparable product
$944.61
$721.645
6
20-9
$1,042.962
FIGURE 3
NPVs for ACEs Major Competitor
from Product Development under Different Actions by ACE
ACE does not introduce Model Z
ACE introduces Model Z at end of Year 1
ACE introduces Model Z at end of Year 2
20-10
$356.275
$(150.00)
$34.955
______________________________________________________________________________
TABLE 1
Net Cash Flows and NPV Analysis of Alternatives
in the Absence of Competing Projects
Panel A
(Status Quo: Model X Only)
Year
1
2
3
Net Cash Flow from

Model X
$400
$300
$200
PV
Factor
0.9091
0.8264
0.7513
NPV =
PV
$363.64
$247.92
$150.26
$761.82
Panel B
(One-Year Plan)
Year
0
1
2
3
4
Net Cash Flow from

Model X
+ Model Z
$ 0
+
$(550)
$ 400
+
$ 0
$ 200
+
$300
$ 100
+
$ 500
$ 0
+
$ 300
=
=
=
=
=
=
Total
$(550)
$ 400
$ 500
$ 600
$ 300
PV Factor
PV
1.0000
$(550.00)
0.9091
$ 363.64
0.8264
$ 413.20
0.7513
$ 450.78
0.6830
$ 204.90
NPV = $ 944.61
Panel C
(Two-Year Plan)
Year
0
1
2
3
4
5
Net Cash Flow from

Model X
+ Model Z
$ 0
+
$(150)
$ 400
+
$(150)
$ 300
+
$ 0
$ 100
+
$ 500
$ 0
+
$ 300
$ 0
+
$ 100
=
=
=
=
=
=
=
Total
$(150)
$ 250
$ 300
$ 600
$ 300
$ 100
PV Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$(150.00)
$227.275
$247.920
$450.780
$204.900
$ 62.090
$ 1,042.965
______________________________________________________________________________
20-11
_____________________________________________________________________________
TABLE 2
Net Cash Flows and NPV Analysis of Alternatives
Assuming Entry by Competition
Panel A
(Status Quo: Model X Only)
Year
1
2
3
Net Cash Flow from

Model X
$400
$300
$100
PV
Factor
0.9091
0.8264
0.7513
NPV =
PV
$363.64
$247.92
$ 75.13
$686.69
Panel B
(One-Year Plan)
Year
0
1
2
3
4
5
Net Cash Flow from

Model X
+ Model Z
$ 0
+
$(550)
$ 400
+
$ 0
$ 200
+
$ 300
$ 100
+
$ 500
$ 0
+
$ 300
$ 0
+
$ 100
=
=
=
=
=
=
=
Total
$(550)
$ 400
$ 500
$ 600
$ 300
$ 100
PV Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$(550.00)
$363.64
$413.20
$450.78
$204.90
$ 62.09
$944.61
PV Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$(150.00)
$227.275
$247.920
$262.955
$102.450
$ 31.045
$721.645
Panel C
(Two-Year Plan)
Year
0
1
2
3
4
5
Net Cash Flow from

Model X
+ Model Z
$ 0
+
$(150)
$ 400
+
$(150)
$ 300
+
$ 0
$ 100
+
$ 250
$ 0
+
$ 150
$ 0
+
$ 50
=
=
=
=
=
=
=
Total
$(150)
$ 250
$ 300
$ 350
$ 150
$ 50
______________________________________________________________________________
20-12
______________________________________________________________________________
TABLE 3
Net Cash Flows and NPV Analysis
of Entering the Market from the Competitions Perspective
Panel A
ACE Does Not Introduce Model Z
Year
0
1
2
3
4
5
Net Cash Flow from New

Product Development & Introduction
$(150)
$(150)
$
0
$ 500
$ 300
$ 100
PV
Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$ (150.000)
$(136.365)
$0.000
$ 375.650
$ 204.900
$ 62.090
$ 356.275
Panel B
(One-Year Plan)
ACE Introduces Model Z at End of Year One
Year
0
1
2
3
4
5

$(150)
$
0
$
0
$
0
$
0
$
0
PV
Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$ (150)
$
0
$
0
$
0
$
0
$
0
$ (150)
Panel C
(Two-Year Plan)
ACE Introduces Model Z at End of Year Two
Year
0
1
2
3
4
5

$(150)
$(150)
$
0
$ 250
$ 150
$ 50
PV
Factor
1.0000
0.9091
0.8264
0.7513
0.6830
0.6209
NPV =
PV
$ (150.000)
$ (136.265)
$
0.000
$ 187.825
$ 102.450
$ 31.045
$ 34.955
_____________________________________________________________________________________
20-13
20-3 ACE Company (B) (Source: Ramji Balakrishnan and Utpal Bhattacharya, ACE Company
(B): The Option Value of Waiting and Capital Budgeting, Issues in Accounting Education, Fall
1997, 12 (2), pp. 403-411.)
The ACE Company case (Chow et al. 1995) introduces strategic dimensions in capital budgeting by
examining the effect of competitive action on the choice between the accelerated and phased development
of a new product. Accelerated development has higher developmental costs and cannibalizes current
product sales but it assured to free out competition. Phased development has lower development costs
spread over two years and reduces cannibalization, but could result in a share market. Accelerated
development is preferred because it has the higher expected net present value (NPV). ACE Company (B)
introduces a third choice: the firm can wait a year before committing to the new product. Accelerated
development dominates this choice if the firm obtains no new information. If, however, the firm obtains
market demand information at the end of the first year, the new choice is preferred because of the implicit
option value to waiting.
The case helps to further cement the ideas developed in the ACE Company case (Chow et al. 1995). In
particular, the case allows the instructor to explore the value to waiting on capital investments. (The
interested reader may wish to go through Dixit and Pindyck (1994, 1995) for more rigorous treatment and
for additional examples.) Second, the case may be used to further explore how game theory is useful in
formulating problems where the optimal solution strategy depends on the choices made by another
strategic player. In particular, this case can be used to illustrate two-stage games and the distinction
between a dominant and a Nash strategy.
The Option Value from Waiting

The following paragraphs describe each alternative investment strategy and its underlying option value. 7
See also the section on classroom strategy.
Choice A (Forgo Investment in Model Z Altogether)
If an irrevocable decision is made to abandon Model Z, there is no option of introducing Model Z at a later
point in time. Hence, there is no option value associated with this alternative. Assume that the competitor
enters. Then, ACEs expected NPV is $686.70 = [(0.5 x $630.35) + (0.5 x $743.95)], where the first term
represents the event that market conditions for Z are good and the second term represents the event that
conditions are bad. See Panel A of Table 2. Similarly, we can calculate expected value when the
competition does not enter as $761.83. Accounting for uncertain entry, ACEs expected value equals
$731.78 = [(0.4 x $686.70) + (0.6 x $761.83)], where the first (second) term represents the event that the
competitor does (does not) introduce Model Z.
The key point is that the mere presence of the opportunity to delay the decision to introduce Model Z
makes irrevocable status quo a dominated choice. In particular, the firm can always decide to introduce
7 This teaching note focuses on the computations for Question 3 (competition can arise and market information will
be obtained). If competition is sure not to emerge and no market information will be obtained (Question 1), notice
that the relevant numbers will change for choices A, C, and D because ACEs sales of Model Z depend on whether
competition emerges. In particular, the expected NPV at time t = 0 is $761.83 for choice A, $944.64 for choice B, and
$1,042.65 for choice C. The corresponding figure is $965.72 = 0.909090 [(0.5 x $1,545.69) + (0.5 x $578.89)] for
choice D. With the maintained assumption, phased development has the highest expected NPV. If, however,
competition is likely to emerge with a 40% chance but no market information will be obtained, ACEs expected NPV
at time t = 0 is $731.78 for choice A, $914.46 for choice C, and $837.19 for choice D. It stays at $944.64 for choice
B. Thus, accelerated development is preferred with the maintenance assumptions.
20-14
Model Z in Year 1, and this option has a non-negative value. We emphasize that the option value does not
arise from obtaining additional information about market demand. Even if ACE would have no additional
information at the start of Year 1, having the option to take the product introduction decision in Year 1 has
a non-negative value. (At best, ACE will choose not to develop Model Z, which is status quo!) If ACE
does obtain additional information, the value will be strictly positive as long as delayed development has
positive NPV for at least one realized state variable.
Choice B (Accelerated Development of Model Z)
This is the preferred choice in ACE Company (A) case, provided there is at least a 30% chance of
competition emerging. This choice is preferred even though total development costs are higher ($550 vs.
$300 in total for phased development) and the cannibalization of Model X sales in Year 2. The benefit, of
course, is that this choice freezes out the competition and ensures high market share. The point to stress is
that this strategy says nothing about market size.
What happens if the firm obtains information about market size at the start of Year 1? Would the firm
choose to abandon Model Z if market conditions were unfavorable? The answer is no because the
development cost is sunk. Even if market demand was bad, introducing Model Z generates incrementally
position cash flows from Year 2 through Year 5. Thus, accelerated development exercises the option of
deferring the decision to introduce Model Z. In other words, the option has expired and thus has no value.
Under this product-development strategy the firm expects to make $944.64 (= 0.5 x $1,477.02 + 0.5 x
$412.27) regardless of the competitors entry decision. The competitors decision is not relevant because
ACE is assumed to obtain a 100% market share if it introduces Model Z at the start of Year 2. See Panel B
of Table 2.
Choice C (Phased Development of Model Z)
Under this strategy, if ACE chooses to ignore updated information about market demand and always
proceeds with Model Z, ACEs expected NPV at time t = 0 (assuming a fixed 40% chance of entry) is
$914.46. This can be calculated as 0.5 x (0.4 x $913.22 + 0.6 x $1,482.45) + 0.5 x (0.4 x $530.11 + 0.6 x
$603.53), where the first (second) term is the event that market conditions are good (bad) and the
expressions within the parentheses adjust for the probability of entry by the competitor. See Panel C of
Table 2.
Notice that ACE has the option of abandoning Model Z at the start of Year 1. This decision would waste
the $150 spent on development in Year 1. However, this cost is sunk for the decision of whether to expend
additional money ($150) to further develop Model Z. What should ACE do at t =1, with the updated
market information? This choice is modeled in Figure 1. Assume that market conditions are good (see tophalf of Figure 1). Then, if ACE proceeds with Model Z, the NPV of its cash flow (at time t = 1) is
$1,545.23 = 0.4 x $1,169.54 + 0.6 x $1,795.69. If ACE chooses to abandon Model Z, the corresponding
NPV is $780.17 = 0.4 x $693.39 + 0.6 x $838.02. Thus, ACE should escalate its commitment of Model Z,
and enter the market if conditions are good and there is a 40% chance of competition arising. A similar
reasoning (the bottom part of Figure 1) shows that ACE should abandon Model Z if market conditions are
bad. The abandonment strategy yields ACE an NPV (at t =1) of $829.76 = 0.4 x $817.36 + 0.6 x $838.02,
while keeping Model Z yields $796.58 = 0.4 x $748.12 + 0.6 x $828.89. The point to emphasize is that the
decision to escalate or not should be taken only with respect to future cash flows. (We stress this point by
comparing cash flows using NPV at time t =1). With this conditional decision and given a 50 percent
chance of good market conditions, ACEs NPV at time t = 0 is $929.54 = (0.5 x [0.4 x $1,169.54 + 0.6 x
$1,794.69] + 0.5 x [0.4 x $817.36 + 0.6 x $838.02]) x 0.9090 - $150.
20-15
The key point here is that, if the option to escalate or abandon did not exist, the phased-development
strategy yields the firm expected profit of $914.46. Having the option increases the expected value to
$929.54. That is, the value of the option to abandon (conditioned on updated market information) is
$15.08 (= $929.54 - $914.46). Additional points that can be stressed are that decisions are subject to
review and that we should only look forward (in a temporal sense) for the decision of whether to escalate
or abandon a project.
Choice D (Delayed Development of Model Z)
Under this strategy, ACE can condition its decision on market information. If market conditions are good,
ACE would like to introduce Model Z, assuming a fixed 40% chance of entry by the competitor.
Specifically, ACEs expected NPV at time t =1 if it introduces Model Z is (see top half of Figure 2)
$1,295.24 = 0.4 x $919.54 + 0.6 x $1,545.69. In contrast, if ACE chooses to abandon Model Z even
though market conditions are good, its expected NPV is $780.62 = 0.4 x $693.39 + 0.6 x $838.02. If,
however, the market is bad, ACE would prefer to abandon Model Z. Introducing Model Z yields NPV (at t
= 1) of $546.58 (= 0.4 x $498.12 + 0.6 x $578.89), while abandoning Model Z yields $829.75 (= 0.4 x
$817.36 + 0.6 x $838.02). (See bottom half of Figure 2.) Hence, given a 50% chance of good market
conditions and a 40% chance of competition emerging, ACEs expected value from delayed development
(at time t =0) is $965.90 = (0.5 x [0.4 x $919.54 + 0.6 x $1,545.69] + 0.5 x [0.4 x $817.36 + 0.6 x
$838.02]) x 0.909090.
The value of delayed development arises because it has the option of tailoring the launch decision to
realized market conditions. To see this, assume that ACE will always introduce Model Z. Then, under
delayed development, using the earlier calculations, ACEs expected NPV is $837.19 = 0.9090 x [0.5 x
$1,295.24 + 0.5 x $546.58]. Thus, the option to delay the launch decision is worth $127.71 = ($965.90 $837.19) under the delayed-development strategy (see Table 3). The point to stress here is that delayed
development is worth $837.19 if we have to make the decision to launch or abort at t = 0. But, the option
of waiting has value. Adding the value of this option ($127.71) then results in delayed development
becoming ACEs best choice (given 40% chance of entry): Choice D ($965.90) > Choice B ($944.64) >
Choice C ($929.54). In sum, ignoring the option value to waiting in the analysis might (and in this case
does) lead to an erroneous product-introduction strategy.
Other examples of the option value from waiting can be introduced at this point. For example, should a
utility build scrubbers to reduce emissions now or should it wait a year (meeting current-year requirements
by buying rights from other utilities)? This decision depends on what new information will become
available in the next year regarding the cost and/or need for scrubbers. The interested reader is referred to
Dix and Pindyck (1994) for more examples.
Game Theory and Optimal Development Strategy
The analysis thus far assumes that the competitors entry decision is independent of realized market
demand conditions. It seems reasonable to assert that the competitor would also get information about
market demand conditions at the end of Year 1. Assuming that the competition can only use the phaseddevelopment strategy to introduce the competing product, its payoff from continuing depends on ACEs
entry decision, and vice versa. What is the equilibrium to the game between the two firms? 8
8 We do not develop the entire solution to this game because such an exercise is likely to be outside the scope of
most management accounting classes. Our focus is on providing an introduction to the differences between a
dominant and a Nash strategy as equilibrium choices. The instructor may wish to refer to McMillan (1992) for a
practical introduction to game theory. Gibbons (1992) provides more rigorous treatment.
20-16
This question can be used to motivate the rationale for modeling situations in which the payoffs for
participants depends on their own and other strategic players actions. (We have assumed a robotic
competitor thus far because we fix the probability of entry at 40%.) For simplicity, begin by considering
only ACEs payoff matrix for the game ACE plays at t = 1. See Figure 3.
By inspection, introducing Model Z is the dominant strategy if phased development is followed and good
market conditions are realized. We emphasize the introduction is a dominant strategy in the sense that the
competitions actions are not relevant to ACEs entry decision! Similar matrices can be constructed to
show that abandoning Model Z is the dominant strategy when conditions are bad. ACEs optimal entry
decisions are also dominant strategies when delayed development is followed. The point is that, while
ACEs payoff does depend on the competitors actions, ACEs optimal choice is driven solely by realized
market conditions only. (The instructor may want to introduce the payoff matrix from the classic
Prisoners Dilemma game here, to cement the idea of a dominant strategy to illustrate how their use could
result in players reaching a Pareto-dominated equilibrium.)
In this particular game, the equilibrium choice at time t = 1 is a dominant strategy. However, dominant
strategies do not exist for many games. For example, consider the normal form presentation of ACEs
payoffs from the product-introduction strategy decision at time t = 0.9 (For simplicity, we have suppressed
the payoff for the competitor.) See Figure 4.
In this game, there is no dominant strategy for ACE. 10 If competition is sure to enter, accelerated
development is better, but delayed development is better if the competition is sure not to enter. The
instructor can, however, point out that delayed development dominates phased-development regardless of
competitive action. Hence, we can eliminate the phased-development row from the matrix, without loss of
generality. But neither accelerated nor delayed development dominates the other. The optimal strategy
depends on beliefs about what the competition will do. (This is the point in the ACE Company (A) case,
although that case assumes a robotic competitor. Recognizing that the competition is a strategic player
triggers the use of game theory to identify the optimal action.) At this point, the instructor can introduce
other games (e.g., battle of the sexes) in which there is no dominant strategy for either player. If time
permits, the concept of a Nash equilibrium can be introduced and illustrated. Alternatively, additional
examples of using game theory to model business simulations can also be introduced (in particular, see
Milgrom and Roberts (1992)) with solution concepts deferred to a later class.
Classroom Strategy
We have successfully used this case in graduate accounting classes. Assigning both the A and the B cases
in one class makes for a tightly packed class, while using up two 75-minute classes allows for a more
leisurely development. The choice depends on the extent to which the instructor wishes to delve into game
theory. If both cases are assigned in one class session, we assign the questions at the end of Case B and tell
students that expected cash flows can be obtained directly from Case A.
We begin by asking a student to sketch out the basic issue. Not much detail is solicited at this point.
Answering Question 1 is a straightforward exercise in computing NPV. We do this to ensure that all
students have identical time-lines and cash flows. This segment tends to go fast in a graduate class and
should not take more than 15 minutes. We next turn to the effect of competitive action. For this segment,
9 Formally, the decision at time t = 1 is a subgame for the game beginning at t = 0. As noted earlier, this subgame has
a solution in dominant strategies. Hence, we use this solution while constructing ACEs payoffs for the game at t = 0,
regardless of its beliefs about entry at t = 0. Also, the payoffs for the phased-development row are adjusted for the
$150 of Year 1 development cost (relative to the payoff for Choice A) when market conditions are bad.
10 The instructor can point out that delayed development beats accelerated development if the entry probability is
less than 47.23%.
20-17
we devote about 30 minutes and focus on decision trees in Chow et al. (1995). For the final segment, we
take one strategy (Choice D) and use the decision tree (specifically, Figure 2) to highlight the value of the
firms real option. A summary sheet (e.g., Tables 2 and 3) containing the other numbers can then be
handed out. Such a condensation is required because reserving 10 minutes for a discussion and summary
leaves only 20 minutes for the discussion of option values. We use the remaining time to discuss other
examples of how the option value from waiting affects investment decisions and (depending on class and
instructor request) applications of game theory to business situations.
References
Chow, C., Y. Hwang, and G. Togo. 1995. ACE Company: A Case for Incorporating Competitive
Considerations into the Teaching of Capital Budgeting, Issues in Accounting Education (Fall): 389402.
Dixit, A., and R. S. Pindyck. 1994. Investment Under Uncertainty. Princeton, NJ: Princeton University
Press.
_______, and _________. 1995. The Options Approach to Capital Investments, Harvard Business
Review 74 (May-June): 105-115.
Gibbons, R. 1992. Game Theory for Applied Economists. Princeton, NJ: Princeton University Press.
Milgrom, P., and J. Roberts. 1992. Economics, Organization and Management. Englewood Cliffs, NJ:
Prentice Hall.
McMillan, J. 1992. Games, Strategies, and Managers. New York, NY: Oxford University Press.
20-18
TABLE 2: Present Value Computations

Choice A: Irrevocably Abandon Model Z
Competitor Enters
Time
Model X
Model Z
PV of Flow
Market for
Z is Good
0
0
0.00
1
400
363.64
2
300
247.93
3
25
18.78
4
0
0.00
5
0
0.00
NPV at time t = 0 of all cash flows
630.35
NPV at time t = 1 of flows from
t = 1 onwards
693.39
Market for
Z is Bad
0
0
1
400
2
300
3
175
4
0
5
0
t = 1 onwards
No Entry by Competitor
Model X
Model Z
PV of Flow
Market for
Z is Good
0
0.00
400
363.64
300
247.93
200
150.26
0
0.00
0
0.00
761.83
838.02
Market for
Z is Bad
0
400
300
200
0
0
0.00
363.64
247.93
131.48
0.00
0.00
743.05
817.36
838.02
Choice B: Accelerated Development

Competitor Enters
Time
Model X
Model Z
PV of Flow
Market for
Z is Good
0
0
-550
-550.00
1
400
0
363.64
2
150
500
537.19
3
25
850
657.40
4
0
550
375.66
5
0
150
93.14
1477.02
Market for
Z is Bad
0
0
-550
-550.00
1
400
0
363.64
2
250
100
289.26
3
175
150
244.18
4
0
50
34.15
5
0
50
31.05
412.27
0.00
363.64
247.93
150.26
0.00
0.00
761.83
Model X
Model Z
PV of Flow
Market for
Z is Good
0
-550
-550.00
400
0
363.64
150
500
537.19
25
850
657.40
0
550
375.66
0
150
93.14
1477.02
Market for
Z is Bad
0
-550
-550.00
400
0
363.64
250
100
289.26
175
150
244.18
0
50
34.15
0
50
31.05
412.27
20-19
TABLE 2 (Continued)
Choice C: Phased Development
Competitor Enters
Time
Model X
Model Z
PV of Flow
Model X
Model Z
PV of Flow
Market for
Market for
Z is Good
Z is Good
0
0
-150
-150.00
0
-150
-150.00
1
400
-150
227.27
400
-150
227.27
2
300
0
247.93
300
0
247.93
3
25
425
338.09
25
850
657.40
4
0
275
187.83
0
550
375.66
5
0
100
62.09
0
200
124.18
913.22
1482.45
t = 1 onwards
1169.54
1795.69
Market for
Market for
Z is Bad
Z is Bad
0
0
-150
-150.00
0
-150
-150.00
1
400
-150
227.27
400
-150
227.27
2
300
0
247.93
300
0
247.93
3
175
75
187.83
175
150
244.18
4
0
25
17.08
0
50
34.15
5
0
0
0.00
0
0
0.00
530.11
603.53
t = 1 onwards
748.12
828.89
Choice D: Delayed Development
Competitor Enters
Time
Model X
Model Z
PV of Flow
Model X
Model Z
PV of Flow
Market for
Market for
Z is Good
Z is Good
0
0
0
0.00
0
0
0.00
1
400
-400
0.00
400
-400
0.00
2
300
0
247.93
300
0
247.93
3
25
425
338.09
25
850
657.40
4
0
275
187.83
0
550
375.66
5
0
100
62.09
0
200
124.18
835.95
1405.18
t = 1 onwards
919.54
1545.69
Market for
Market for
Z is Bad
Z is Bad
0
0
0
0.00
0
0
0.00
1
400
-400
0.00
400
-400
0.00
2
300
0
247.93
300
0
247.93
3
175
75
187.83
175
150
244.18
4
0
25
17.08
0
50
34.15
5
0
0
0.00
0
0
0.00
452.84
526.26
t = 1 onwards
498.12
578.89
20-20
______________________________________________________________________________
FIGURE 1
Decision Tree Under Choice C (Phased Development)*
Node
NPV @ t = 1
Entry
$1,169.54
No Entry
$1,795.69
$ 693.39
No Entry
$ 838.02
Entry
$ 748.12
$ 828.89
Keep Model
Z
Market
Good
Entry
Drop Model
Z
t=1
Keep Model
Z
No Entry
Market Bad
Entry
$ 817.36
Drop Model
Z
No Entry
8
$ 838.02
______________________________________________________________________________
* The NPV for the various nodes can be obtained from Table 2. Also, notice that nodes 3, 4, 7, and 8, the
relevant payoffs to ACE can be derived from looking at the payoffs associated with Choice A (abandon Z)
in Panel A of Table 2. Finally no adjustment is required for the $150 of development expense incurred in
Year 1 because it is sunk for the decision at hand. To determine NPV at t = 0, these NPVs have to be
discounted to t = 0 and $150 deducted for the development cost planned for Year 1.
20-21
______________________________________________________________________________
FIGURE 2
Decision Tree Under Choice D (Delayed Development)*
Node
NPV @ t = 1
Entry
$ 919.54
No Entry
$ 1,545.69
$ 693.39
No Entry
$ 838.02
Entry
$ 498.12
$ 578.89
Keep Model
Z
Market
Good
Entry
Drop Model
Z
t=1
Keep Model
Z
No Entry
Market Bad
Entry
$ 817.36
No Entry
$ 838.02
Drop Model
Z
______________________________________________________________________________
20-22
*The NPV for the various nodes are in Table 2. Also, notice that for nodes 3, 4, 7, and 8, the relevant
payoffs to ACE are obtained from looking at the payoffs associated with Choice A (abandon Z) in Panel A
of Table 2.
20-23
______________________________________________________________________________
TABLE 3
Expected NPV (at t = 0) of Available Development Strategies
Development Strategy
Irrevocably abandon
Accelerated development
Phased development
Delayed development
No Option
$ 731.78
$ 944.64
$ 914.46
$ 837.19
With Option
$ 731.78
$ 944.64
$ 929.54
$ 965.90
*The option value for phased-development is $929.54 - $914.46 = $15.08. The option value for delayed
development is $965.90 - $837.19 = $128.81.
_____________________________________________________________________________________
_____________________________________________________________________________________
FIGURE 3
Payoff Matrix for Game Between ACE and Competitor (t = 1)*
Competition Enters Competition Does Not Enter
Panel A: Market Conditions are Good
ACE Enters--Choice D
ACE Enters--Choice C
ACE Does Not Enter
$ 919.54
$1,169.54
$ 693.39
$ 1,545.96
$ 1,795.69
$ 838.02
Panel B: Market Conditions are Bad

ACE Enters--Choice D
ACE Enters--Choice C
ACE Does Not Enter
$ 498.12
$ 748.12
$ 817.36
$ 578.89
$ 828.89
$ 838.02
*The number in the first row of each panel is obtained directly from Table 2. The numbers in the second
row of each panel are obtained from the payoffs associated with Choice A (abandon Model Z) in Panel A
of Table 2.
_____________________________________________________________________________________
_____________________________________________________________________________________
FIGURE 4
Payoff Matrix for Game Between ACE and Competitor (t = 0)*
Accelerated
Phased
Delayed
Competition Does Not Enter

$ 944.64 (0.5 x [$1,477.02 + $ 412.27])
$1,047.14 (0.5 x [$1,482.45 + $ 611.83])
$1,083.50 (0.5 x [$1,405.18 + $ 761.83])
Competition Enters
$ 944.64 (0.5 x [$1,477.02 + $412.27])
$ 753.13 (0.5 x [$ 913.22 + $ 593.05])
$ 789.51 (0.5 x [$ 835.95 + $ 743.05])
*For the phased and delayed development strategies, notice that ACE would abandon Model Z if market
conditions were bad. Such abandonment is optimal regardless of the competitors entry decision.
_____________________________________________________________________________________
20-24
20-4 Component Technologies, Inc.: Adding FlexConnex Capacity (Julie H. Hertenstein, Issues
in Accounting Education, Vol. 15, No. 2 (May 2000), pp. 257-261.)
ABSTRACT: Component Technologies, Inc. (CTI) manufactures components used in electronic devices.
CTI is considering adding manufacturing capacity for FlexConnex to meet increased future demand. CTIs
manufacturing planning staff identifies three options to meet this demand. The staff performs preliminary
financial analyses to evaluate whether to conduct detailed planning for and evaluation of each of the three
options. During their analysis, they consider which discount rate is more appropriate: the 20% rate, which
the corporate finance manual states is the hurdle rate for capital investments, or 10%, which the staff
believes is closer to the corporate cost of capital. They experiment with both discount rates, and two time
horizons. This case requires you to calculate net present values (NPVs) and to analyze the effect of
different discount rates and time horizons. It also asks you to consider the effect of other financial and
nonfinancial issues on your analysis.
TEACHING NOTES
Component Technologies, Inc. (CTI) manufactures components used in computers and other electronic
devices. CTI is considering a capital investment to increase manufacturing capacity for a key product,
FlexConnex, to meet increased demand forecast for the future. The CTI manufacturing planning staff
identifies three options to meet the increased demand. One involves expansion of the existing
manufacturing facility in Santa Clara, California and will utilize the existing technology. The second
involves use of a Waltham, Massachusetts manufacturing facility, whose product is being phased out; it
also would utilize the existing technology. A third option would require the company to build a brand new
(Greenfield) plant in Ireland; it would utilize a newer manufacturing technology. Associated with this third
option and the new technology is a higher level of capital investment, but lower variable cost per unit, and,
if full capacity is reached, lower fixed costs per unit.
The CTI staff proposes performing a preliminary financial analysis of the three options to evaluate
whether it is worthwhile to conduct detailed planning and evaluation on each option. During their
preliminary analysis, they consider which of two discount rates is more appropriate for their analysis, the
20% rate that the corporate finance staff states is to be used in capital investment analysis, or the 10% rate
that they consider closer to the actual cost of capital for CTI. They decide to perform several NPV
calculations, experimenting with both discount rates, and with two time horizons.
INTENDED COURSES AND AUDIENCE
This case was designed for an introductory module on capital investment and NPV for graduate courses
and executive programs. It is appropriate for use in courses in management accounting, management
control systems, finance, or capital budgeting. The case assumes that students have already been
introduced to basic discounted cash flow (DCF) concepts, and that they can calculate the NPV of an
uncomplicated set of cash flows. It is a relatively simple case for students to understand, and the required
calculations are straightforward. Yet the case is rich enough to support discussion of a variety of capital
budgeting issues, depending on the experience of the students and the instructors objectives.
I have taught this case at least a dozen times, most frequently in required managerial accounting courses in
one of two M.B.A. programs. One program is a fairly traditional M.B.A. program populated by students in
their mid-to-late twenties with two-to-five years of work experience. The second program is an executive
M.B.A. program whose participants typically have 15 or more years of work experience, considerable
managerial experience, and hold senior positions with significant decision-making authority. In addition, a
colleague and I each have taught the case in corporate executive programs for companies such as General
Electric and Molex Corporation. The topic of the corporate programs varied from a specific focus, for
20-25
example, Investing in New Technologies, to a broader managerial accounting focus, Measuring and
Managing the Costs of Doing Business.
The pedagogy in both the M.B.A. courses and the corporate executive courses was primarily case
discussion.
What students find the most eye-opening about this case is the fact that raising (or lowering) the discount
rate changes the ranking of the various projects. Until they encounter this case, many students assume that
raising the discount rate simply creates a higher hurdle for each project, and that if the discount rate is
raised enough, the lowest-ranked project will simply become unattractive (that is, it will have a negative
NPV). It never occurs to them that the lowest-ranked project could become the highest-ranked project!
Another intriguing aspect of this case is the opportunity to discuss how challenging it can be to propose an
investment in new technology required to sustain competitiveness, especially when that investment is
compared to incremental investments in existing technologies. In this situation, it is important not only to
conduct thoughtful financial analyses with appropriate discount rates, but also to incorporate key
nonfinancial issues into the analysis. As discussed later in these Teaching Notes, this aspect of the case
creates the opportunity to discuss the notion of real options in capital investments, analogous to the
concept of financial options related to financial assets.
One limitation of the case is that it requires numerous calculations.
TEACHING OBJECTIVES
This case is designed to give students opportunities to practice calculating NPVs. The case is also
designed to allow the analysis and discussion to move considerably beyond calculations and into a broader
discussion of issues encountered in applying discounted cash flow analysis, and other issues in capital
investment analysis. Specifically, the case provides opportunities for students to:
1) Organize relevant cash flow information and calculate NPVs. Cash flows required for the analysis are
given in the case, but students must organize the information to analyze each alternative.
2) Analyze the impact of changing the discount rate, and assess the importance of selecting an appropriate
rate when a firm specifies the rate to be used by managers in preparing capital investment proposals.
3) Analyze why NPVs change as they do when different time horizons are used and think critically about
appropriate time horizons.
4) Identify cash flows missing from the preliminary analysis and evaluate their likely impact, for
example, terminal values, taxes, and opportunity costs.
In addition, the case also provides opportunities for the instructor to broaden the discussion beyond DCF
analysis to factors that, while not amenable to financial measurement, are important to consider in the
decision. Specifically, the discussion might include:
a)
b)
c)
d)
e)
Benefits of locations other than Santa Clara (especially Ireland).

Competitive implications of technology choice.
Impact of uncertainty about demand or price on each alternative.
Additional alternatives structured through critical thinking about the DCF analysis.
Introduction to the concept of real options in capital investment.
20-26
Optional Assignment Questions

A) Prepare an analysis of the three alternatives using a 20% discount rate and a ten-year time horizon.
Compare this analysis to that using a 10% discount rate and a ten-year time horizon. What happens to
the ranking of the three alternatives? Why?
B) The land at the Santa Clara site, and the land, building and some of the equipment at the Waltham site
were not incremental costs to CTI, and they were not included in the groups estimates of required
investment. When, if at all, should items that are not incremental costs or expenditures be included in
the analysis? How would you determine their cost? If you think it is appropriate to include such costs
in the evaluation of Santa Clara and/or Waltham, describe the likely effect of their inclusion on the
analysis.
C) What consideration, if any, should be given to terminal value at the end of ten years? How would that
affect the respective NPVs? How much would terminal values have to be to change the decision?
D) Assume the corporate income tax rate in the U.S. is twice the rate in Ireland. How would your analysis
be affected if taxes were included? (Assume no other changes.)
E) Some experts think there is a reasonable chance that CTIs sales of FlexConnex will not exceed 125
million units annually. How does this affect your analysis? Does it suggest that CTI should approach
any of these alternatives differently?
TEACHING PLAN
In a 90-minute class, approximately the first half of the class would be spent on reviewing the calculations.
The calculations are outlined in the Issues for Analysis and Discussion section, below.
The instructor can choose one of two basic approaches to reviewing the calculations: the instructor can
present the calculations and the results to the class; alternatively, the instructor may wish to have students
present (at least some of) the calculations. Factors that may influence this choice are the students prior
experience with NPV calculations, and length of the class period. For students with little experience
calculating NPVs, having them present at least the first set of calculations provides the opportunity to
work systematically through the calculations to ensure that everyone understands them and increases
students skill at presenting such information. On the other hand, if students have previously completed
NPV assignments, the instructor may choose to simply review the calculations on overheads (such as those
in the exhibits to these Teaching Notes) and respond to questions that students raise. Instructors may also
choose this approach if their class period is shorter, or if they simply wish to allow more time for
discussion of the issues.
The second half of the class can be spent discussing various issues related to the calculations and the
investment alternatives, which are outlined below in the Issues for Analysis and Discussion section,
following the calculations. This case contains many possible issues for discussion, probably more than can
be covered in a 90-minute class. Instructors can select those issues they consider most important to focus
on.
The instructor can approach the discussion of issues broadly, for example, What other factors should we
consider in deciding whether to evaluate each of these three alternatives in depth? This approach allows
students to identify issues for discussion. Alternatively, the instructor can adopt a more focused approach,
directing questions to issues of the instructors choice, such as those given in the Optional Assignment
Questions. Thus, the instructor might ask, How should we treat the terminal value in the analysis? or
What might be the potential advantages or disadvantages of having a plant located in Ireland?
A useful way to end the class is to have students vote on whether they would evaluate in-depth and
detailed plans for each of the three alternatives (and/or other alternatives they have identified in the
20-27
discussion). The vote will reinforce the preliminary nature of this analysis; since the data are preliminary,
it is reasonable to continue to pursue more than one alternative. But the vote will also emphasize the
importance of preliminary choices that managers make. Managers define sets of alternatives that will and
will not be considered. It is important to avoid missed opportunities, i.e., profitable opportunities that
the company failed to consider.
ISSUES FOR ANALYSIS AND DISCUSSION
Question 1a: Five Years of Cash Flows Discounted at 20 Percent
First, the demand for the new plant or the expansion must be calculated. To begin, forecast total FlexConnex demand,
which the case states will increase by 10 percent annually. Then the demand for the new capacity can be determined
by subtracting the volume that can be met with the existing Santa Clara capacity (75 million units
annually). See Exhibit TN-1.
Next, cash flows can be calculated for Santa Clara, Waltham, and Ireland based on demand, calculated in
the previous step, and data in the case. The cash flows for the three alternatives are shown in the top panel
of Exhibits TN-2, TN-3, and TN-4, respectively. At the bottom of the first panel of the corresponding
exhibits, cash flows are discounted at 20% to 1993 dollars, which Tom Richards indicates in the case text
they will use. (The cash flows are also discounted at 10% to 1993 dollars, which will be discussed later.)
Assignment Question 1a asks students to discount five years of cash flows at 20%. The bottom panel,
labeled NPV Summary, of the respective exhibits shows the NPV for five years at 20 percent; the
amount shown is the sum of the values for the first five years shown in the top panel. Once the NPVs for
five years at 20% have been developed, they can be posted on a summary chart, as shown in the first
line of Exhibit TN-5. The summary chart will be used to highlight changes as further sets of calculations
are completed using different parameters.
Students can be asked to interpret the results. Under these parameters, Waltham appears attractive, Ireland
is very unattractive, and Santa Clara is marginally unattractive. The Waltham and Santa Clara alternatives
result in almost the same level of additional capacity, but Waltham requires less capital investment.
Although fixed costs at Waltham are projected slightly higher than at Santa Clara, these costs represent
future cash outflows which, once discounted, have less incremental impact on the calculation, so the major
difference between the Waltham and Santa Clara numbers is the initial investment required. The extreme
unattractiveness of Ireland is due, in part, to the large magnitude of investment required, and to the fact
that for the five-year period, demand is significantly below the 70-million unit capacity of the plant.
Question 1b: Five Years of Cash Flows Discounted at 10 Percent
Next, the present values can be computed using the same five years of cash flows, but with a 10% discount
rate (see the 10% discount rate lines in Exhibits TN-2, TN-3, and TN-4) and the values can be posted on
the summary chart (Exhibit TN-5). By examining the summary chart at this stage, students can observe:
(1) the rank order of the three alternatives remains the same, (2) the NPV for each alternative improves
with the lower discount rate, (3) the Santa Clara alternative moves from unattractive to attractive, and (4)
the Ireland alternative remains very unattractive for reasons previously stated. The increased NPV of all
three alternatives results from the fact that, while the present value of both cash inflows and cash outflows
are increased with the lower discount rate, the cash inflows benefit more as they occur largely in the later
years, where the compounding effect of reducing the discount rate has greater impact.
20-28
______________________________________________________________________________________________
EXHIBIT TN-1
FlexConnex Supply-Demand Analysis
(000,000 Units)
Total Demand
Santa
Santa Clara
Waltham
Ireland
(@ 10% annual Clara Excess
Expansion
Factory
Factory
Year growth rate) Capacity Demand Production Shortage Production Shortage Production Shortage
1994
75.0
75.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
1995
82.5
75.0
7.5
7.5
0.0
7.5
0.0
7.5
0.0
1996
90.8
75.0
15.8
15.8
0.0
15.8
0.0
15.8
0.0
1997
99.8
75.0
24.8
24.8
0.0
24.8
0.0
24.8
0.0
1998
109.8
75.0
34.8
30.0
4.8
25.0
9.8
34.8
0.0
1999
120.8
75.0
45.8
30.0
15.8
25.0
20.8
45.8
0.0
2000
132.9
75.0
57.9
30.0
27.9
25.0
32.9
57.9
0.0
2001
146.2
75.0
71.2
30.0
41.2
25.0
46.2
70.0
1.2
2002
160.8
75.0
85.8
30.0
55.8
25.0
60.8
70.0
15.8
2003
176.8
75.0
101.8
30.0
71.8
25.0
76.8
70.0
31.8
_____________________________________________________________________________________
_____________________________________________________________________________________________
EXHIBIT TN-2
Santa Clara Expansion
(000,000s)
1993
1994
0.0
1995
7.50
1996 1997 1998 1999

15.75 24.83 30.00 30.00
2000
30.00
2001 2002
30.00 30.00
2003
30.00
Units Sold
Sales Revenue
(@ $0.85/unit)
Variable Costs
(@ $0.255/unit)
Fixed Costs
Investment
Net Cash Flows
0.00 (1.91)
0.00 (2.10)
(23.00) 0.00
($23.00) $2.36
(4.02) (6.33) (7.65) (7.65) (7.65) (7.65) (7.65) (7.65)

(2.10) (2.40) (2.40) (2.40) (2.40) (2.40) (2.40) (2.40)
0.00 0.00
0.00
0.00
0.00
0.00 0.00
0.00
$7.27 $12.37 $15.45 $15.45 $15.45 $15.45 $15.45 $15.45
PV in 1993 Dollars:
@ 20%
@ 10%
($19.17) $1.64
($20.91) $1.95
$4.21 $5.97
$5.46 $8.45
$0.00 $6.38 $13.39 $21.10 $25.50 $25.50 $25.50 $25.50 $25.50 $25.50
$6.21
$9.59
$5.17
$8.72
$4.31
$7.93
$3.59 $2.99
$7.21 $6.55
$2.50
$5.96
NPV Summary
Calculation Period: 5 Years
@ 20%
($1.14)
$17.43
@ 10%
$4.55
$40.92
_____________________________________________________________________________________
20-29
______________________________________________________________________________________________
EXHIBIT TN-3
Waltham Factory
(000,000s)
1993
Units Sold
Sales Revenue
(@ $0.85/unit)
Variable Costs
(@ $0.255/unit)
Fixed Costs
Investment
Net Cash Flows
1994
0.0
$0.00
1995 1996 1997 1998 1999

7.50 15.75 24.83 25.00 25.00
2000
25.00
2001
25.00
2002 2003
25.00 25.00
$6.83 $13.39 $21.11 $21.25 $21.25 $21.25 $21.25 $21.25 $21.25
0.00 (1.91) (4.02) (6.33) (6.38) (6.38) (6.38) (6.38) (6.38) (6.38)
0.00 (2.40) (2.40) (2.60) (2.60) (2.60) (2.60) (2.60) (2.60) (2.60)
(7.00)
0.00 (7.00)
0.00
0.00
0.00
0.00
0.00
0.00 0.00
($7.00) $2.06 ($0.03) $12.17 $12.28 $12.28 $12.28 $12.28 $12.28 $12.28
PV in 1993 Dollars:
@ 20%
@ 10%
($5.83)
($6.36)
$1.43 ($0.02)
$1.70 ($0.02)
$5.87
$8.31
$4.93
$7.62
$4.11
$6.93
$3.43
$6.30
$2.85
$5.73
$2.38
$5.21
$1.98
$4.73
NPV Summary
@ 20%
$6.38
$21.13
@ 10%
$11.25
$40.14
_____________________________________________________________________________________
_____________________________________________________________________________________
EXHIBIT TN-4
Ireland Factor
(000,000s)
1993
1994 1995 1996
Units Sold
0.00
0.0
7.50 15.75
Sales Revenue
(@ $0.85/unit)
$0.00
0.00 $6.83 $13.39
Variable Costs
(@ $0.255/unit)
0.00
0.00 (1.46) (3.07)
Fixed Costs
0.00
0.00 (2.80) (2.80)
Investment
(6.10) (42.70) (12.20) 0.00
Net Cash Flows ($6.10)($42.70)($10.09) $7.52
1997 1998 1999

24.83 34.80 45.80
2000
57.90
2001
70.00
2002 2003
70.00 70.00
$21.11 $29.58 $38.93 $49.22 $59.50 $59.50 $59.50

(4.84) (6.79) (8.93) (11.29) (13.65) (13.65)(13.65)
(2.80) (2.80) (2.90) (2.90) (2.90) (2.90) (2.90)
0.00
0.00
0.00
0.00
0.00
0.00 0.00
$13.46 $19.99 $27.10 $35.02 $42.95 $42.95 $42.95
PV in 1993 Dollars:
@ 20%
@ 10%
($6.10) ($35.58) ($7.01)

($6.10) ($38.82) ($8.34)
$4.35
$5.65
$6.49 $8.04 $9.08 $9.77 $9.99 $8.32 $6.94

$9.19 $12.41 $15.30 $17.97 $20.04 $18.21 $16.56
NPV Summary
@ 20%
($29.81)
$14.29
@ 10%
($26.00)
$62.08
_____________________________________________________________________________________
20-30
______________________________________________________________________________________________
EXHIBIT TN-5
CTI Summary
($000,000)
5 Years:
5 Years @ 20%
5 Years @ 10%
Santa Clara
Waltham
($1.14)
$4.55
$ 6.38
$11.25
Ireland
($29.81)
($26.00)
10 Years:
10 Years @ 20%
$17.43
$21.13
$14.29
10 Years @ 10%
$40.92
$40.14
$62.08
_____________________________________________________________________________________
_____________________________________________________________________________________
EXHIBIT TN-6
_____________________________________________________________________________________
20-31
Question 1c: Ten Years of Cash Flows Discounted at 10 Percent

The next analysis extends the just-completed five-year analysis for an additional five years at a 10%
discount rate. Further, even if students have not been assigned Optional Assignment Question A, which
asks them to compute present values of ten-year cash flows at a 20% discount rate, it is enlightening for
the instructor to provide these figures. The NPVs for ten years of cash flows discounted at 10% and at
20% are shown in the ten-year column of the bottom panel of Exhibits TN-2, TN-3, and TN-4,
respectively. All six values can then be posted on the summary chart (Exhibit TN-5) and illustrated
graphically (Exhibit TN-6).
Students can again discuss what has changed and why. The additional five years of cash inflows
discounted at the 10 percent discount rate makes each alternative more attractive. However, Ian states he
has bad news for the others, because the proposal for the Greenfield plant in Ireland now looks
substantially better than the other two. It takes longer for the plant in Ireland to reach full capacity, so a
ten-year horizon is required before the benefit of the larger capacity can be observed. Further, the other
plants will be limited by their lower capacity, and will not be able to meet the anticipated demand for the
full ten years. This illustrates that if you build a plant with a ten-year capacity, it does not make sense to
terminate the analysis at five years (especially without a sound terminal value built into the analysis;
terminal value will be discussed further, below).
A second, important point should be made while discussing the calculations in Question 1. Students
should be asked to observe what has happened to the ranking of the alternatives with 10-year time
horizons. Using a 20% discount rate, NPVs from highest to lowest are: (1) Waltham, (2) Santa Clara, and
(3) Ireland. But when the 10 percent discount rate is used the order is: (1) Ireland, (2) Santa Clara, and (3)
Waltham. The reason the rankings change is that Irelands most significant cash inflows, resulting from its
ability to take advantage of its much larger capacity, are those in the furthest-out years. But it is precisely
those distant cash flows that (due to compounding) benefit most from reducing the discount rate from 20
percent to 10 percent. Thus, when the patterns of cash flows are different for different alternatives, raising
(or lowering) the discount rate not only lowers (or raises) the present value of each alternative, it can
change the ranking of the alternatives, as well.
The discount rate that managers are required to use to evaluate capital investments (often called the
hurdle rate) is typically selected by the corporate finance staff, and communicated to managers via the
corporate finance manual or the capital budgeting manual. Very high discount rates systematically
discriminate against longer horizon, slower developing investments; these characteristics often epitomize
innovative investments. Thus, selecting an appropriate discount rate to use to calculate NPVs is a crucial
decision that can influence the types of investments a company will undertake.
There is sound theory to support use of the firms cost of capital as a required hurdle rate, and the cost of
capital can be reasonably and reliably estimated. There is also theory to support increments to the rate for
additional risk. However, there is less guidance to estimate the amount of the increment for a given capital
project risk. Unlike one share of GM common stock, which has the same risk as another share of GM
stock, all real assets are in some way unique, with unique risks. Further, one can argue that the
FlexConnex investments represent no more than average risk for CTI, as the product is in their mainline
business, the market is already established, and growth in demand is well understood, at least in the near
future. This would argue for a required hurdle rate close to the firms cost of capital. Requiring managers
to use a hurdle rate that is double the firms cost of capital, as CTI is apparently doing, raises suspicions
that the corporate office is not only adding a risk adjustment component, but it may be adding an
SG&A increment as well, as many companies do (Kaplan 1986). Typical reasoning used to support an
SG&A increment is that value-adding investments, such as FlexConnex, must earn enough to cover their
own costs plus some costs of non-value-adding investments the firm might makefor example, to
comply with government regulations, or other administrative investments. The results of increasing the
discount rate for such reasons will be to eliminate potentially positive NPV investments from
consideration, and to systematically discriminate against the longer horizon, slower developing
investments (Kaplan 1986).
The instructor may next choose to focus on three additional items identified in Optional Assignment
Questions B, C, and D, which could be included in the NPV analysis: opportunity costs, terminal values,
and taxes. The instructor can deal with these issues at a conceptual level, or can provide rough estimates
(or ask students to provide rough estimates) and incorporate these estimates into the NPV calculations. As
discussed below, including any of these three factors in the NPV analysis would favor the site in Ireland
relative to the two other sites.
Optional Assignment Question B: The land at the Santa Clara site, and the land, building and some
of the equipment at the Waltham site were not incremental costs to CTI, and they were not included
in the groups estimates of required investment. When, if at all, should items that are not
incremental costs or expenditures be included in the analysis? How would you determine their
cost? If you think it is appropriate to include such costs in the evaluation of Santa Clara and/or
Waltham, describe the likely effect of their inclusion on the analysis.
A clear case can be made for including an opportunity cost if Waltham is selected. Walthams current
product line is being phased out. It is reasonable to expect that the Waltham facility, if not used to
manufacture FlexConnex could be used to manufacture another product, or it could be sold.
The opportunity cost associated with Santa Clara is less clear. If the expansion space at the plant is not
used for FlexConnex, it may not be possible to use this space to manufacture another product, and it
seems unlikely that CTI would sell or lease space in the middle of their manufacturing site.
Optional Assignment Question C: What consideration, if any, should be given to terminal value at
the end of ten years? How would that affect the respective NPVs? How much would terminal values
have to be to change the decision?
Conceptually, each alternative is likely to have a positive terminal value, which will increase its NPV.
One could argue that the plant in Ireland will have a relatively higher terminal value as the newer
technology will be more likely to have future uses, and will better retain its value. Using the ten-year
horizon and 10% discount rate, the terminal value for Santa Clara (or Waltham) would have to exceed that
for Ireland by more than 20 million 1993-dollars (52 million 2003-dollars) to change the decision.
Optional Assignment Question D: Assume the corporate income tax rate in the U.S. is twice the rate
in Ireland. How would your analysis be affected if taxes were included? (Assume no other changes.)
Taxes are clearly cash costs, which will lower NPV. Further, Ireland has traditionally kept corporate tax
rates low to attract firms to locate in Ireland. Thus a lower tax rate in Ireland than the U.S. would reduce
the NPV of the Ireland alternative less (relatively) than the reduction in NPV due to taxes for the U.S.
alternatives.
Question 2: In addition to reducing costs, the new technology proposed for the greenfield plant
would increase manufacturing flexibility, which would enable CTI to respond more quickly to
customers and to provide them more custom features. Should these factors be considered in the
analysis? If so, how would you incorporate them?
The choice of the new technology over the old has clear implications for reducing product cost as well as
other customer value implications such as faster response and providing more custom features. (Students
may infer other benefits, but none are specifically identified in the case.)
Although the direct, financial benefit of the new technologys improved product cost structure has already
been incorporated in the discounted present value analysis, the benefit that is not captured in the NPV is
the increased competitiveness the new technology will provide. The lower cost structure will increase
CTIs potential pricing flexibility so that it can act proactivelyfor example, by providing price discounts
to large customersas well as react to price reductions by competitors. (See Exhibit TN-7 for product
cost calculations at the existing and proposed manufacturing plants at full capacity. 1) Students can be
encouraged to consider what costs or risks CTI faces if competitors adopt the new technology, and CTI
does not. CTI would be vulnerable to the competitors pricing products similar to FlexConnex below
CTIs cost. CTI could be forced into an unprofitable situation, and/or might have to close down this
business; both are costly outcomes and these costs are not incorporated into the discounted cash flow
analysis.
_____________________________________________________________________________________________
EXHIBIT TN-7
Product Cost Calculations at Full Capacity
Units at Capacity
Investment
Annual depreciation
(10 years, SL)
Other fixed costs
(excluding depreciation)
Depreciation/unit
Other fixed costs/unit
Existing
Santa Clara
75 million
Santa Clara
Expansion
30 million
$23 million
Waltham
Factory
25 million
$14 million
Ireland
Factory
70 million
$61 million
$2.5 million
$2.3 million
$1.4 million*
$6.1 million
$7.0 million
$2.4 million
$2.6 million
$2.9 million
$0.034
$0.093
$0.077
$0.080
$0.056*
$0.104
$0.087
$0.041
Unit Product Cost:

Variable cost
$0.255
$0.255
$0.255
$0.195
Depreciation
0.034
0.077
0.056*
0.087
Other fixed costs
0.093
0.080
0.104
0.041
Total cost/unit
$0.382
$0.412
$0.415*
$0.323
____________________
*These figures include depreciation only for the additional investment required at Waltham. Depreciation
for existing property and equipment that would be used at the Waltham facility would be added to these
amounts. The amounts shown are therefore understated.
_____________________________________________________________________________________
1
Of course, if the 70-million-unit plant is built in Ireland, it will have more idle capacity in the early years than
would the smaller alternative plants. If the cost of this idle capacity is allocated to the cost of the units produced,
then these units will appear to have a much higher cost. Problems associated with allocating the cost of idle
capacity to products are well known (for an excellent example, see the Bridgeton Industries: Automotive
Component & Fabrication Plant, Case #9-190-085 Harvard Business School Publishing). In situations where idle
capacity is expectedfor example, when beginning production in a new facilitycompanies may base their cost
allocation on the rated capacity (perhaps adjusted for required nonproductive tasks) to avoid problems of
overcosting, and potentially overpricing, products. The cost of idle capacity will appear separately, either by that
name, or another such as volume variance. For an example, see the Polysar Ltd. Case #9-187-098, Harvard
Business School Publishing.
_____________________________________________________________________________________________________________________
EXHIBIT TN-8
Prices for Alternative Price Scenarios
Decline
5%
5%
10%
10%
Year
1999
1996
1999
1996
1995
$0.85
$0.85
$0.85
$0.85
1996
$0.85
$0.81
$0.85
$0.77
1997
$0.85
$0.77
$0.85
$0.69
1998
$0.85
$0.73
$0.85
$0.62
1999
$0.81
$0.69
$0.77
$0.56
2000
$0.77
$0.66
$0.69
$0.50
2001
$0.73
$0.62
$0.62
$0.45
2002
$0.69
$0.59
$0.56
$0.41
2003
$0.66
$0.56
$0.50
$0.36
_____________________________________________________________________________________________________________________
_____________________________________________________________________________________________________________________
EXHIBIT TN-9
NPV under Alternative Price Scenarios
(000,000)
Annual Price
Decline
5%
5%
10%
10%
Beginning
Year
1999
1996
1999
1996
Santa Clara
$33.10
$21.34
$26.14
$ 5.81
Waltham
$33.63
$23.53
$27.84
$10.28
Ireland
$44.80
$24.82
$29.70
($3.79)
__________________________________________________________________________________________________________________
Similarly, the customer benefits of faster response and more custom feature availability are not
incorporated in the discounted cash flow analysis. Although the financial value of these benefits would be
difficult to project at this time, students can be encouraged to consider how CTI might benefit. These
factors might attract additional customers to CTI or might allow CTI to charge more for customized
products. Both produce increased revenue, hence increased NPV, for the Ireland alternative. Alternatively,
these factors might help CTI avoid the loss of customers to competitors who offer similar advantages,
again a financial benefit for CTI (Kaplan 1986). 2
Question 3: Should other factors be taken into consideration in choosing the location of the
FlexConnex plant? If so, what are they?
Benefits of Locating in Ireland
Locating a plant in Ireland might provide several benefits to CTI. The Irish plant might have close
proximity to some of CTIs key customers headquarters or their manufacturing plants, especially given
the international and global nature of the CTI customers identified in the case. This, in turn, might help
CTI to provide superior service to these customers, and it might increase CTIs awareness of the
customers future plans, which could improve CTIs chances of obtaining additional business from these
customers. The Ireland location might also provide CTI closer proximity to some of its suppliers,
although the case contains no specific evidence to support this hypothesis. Advantages might accrue from
having the plant located within the European Economic Community (EEC), such as reduced duties and
tariffs, or favorable perceptions, public relations advantages, and political benefits. The magnitude of the
reduced duties and tariffs is something that could be estimated during detailed evaluation of the Ireland
alternative.
On the other hand, locating the plant in Ireland requires CTI to be able to coordinate with and manage a
distant facility; this would be true for Waltham as well. However, given CTIs apparent size and its global
marketing strategy and customers, it seems likely that CTI already has experience managing distant (even
overseas) plants.
Effect of Uncertainty about Demand or Price
CTI faces strategic uncertainty about the future demand and price for its FlexConnex product. Although
products like connectors do not experience the same rate of technological change and product
obsolescence as other computer components (for example, processor chips) there are potential
competitive pressures. Thus, one should consider what would happen if demand and product price differ
from what the manufacturing planning staff expects in the case. A starting point is the alternative demand
assumption given in the optional questions.
Optional Question D: Maximum Demand is 125 Million Units
If overall demand peaks at 125 million units in 2000, only the plant in Ireland will be affected since the
Santa Clara and Waltham plants reach capacity at a total annual demand of 105 million and 100 million
units, respectively. If demand peaks at 125 million units in 2000, and remains at that level through 2003,
then total annual volume in the plant in Ireland will be 50 million units for these years. Discounting the
resulting cash flows for the years 19932003 at 10 percent gives a NPV of $42.71 million. This is less
than at the higher volume in Ireland, but still better than Santa Clara or Waltham.
______________
2
Factors like the benefits of locating in Ireland, or the benefits of the new technology, while ultimately having
financial value, are difficult, if not impossible, to estimate at this early stage. One approach that would incorporate
nonfinancial factors systematically into the decision framework is the Analytic Hierarchy Process (AHP), which is
described in Monahan et al. (1990). This model provides a formal, systematic, alternative to informal strategic
judgment. AHP links analysis of financial and nonfinancial factors to the strategic objectives of the business.
Additional Demand Scenarios

If demand fails to develop, or develops more slowly than expected, or if demand for the product fails to
be sustained for ten years, then the Ireland alternative is most vulnerable. Students can be encouraged to
run additional scenarios to evaluate the sensitivity to different levels of, or growth rates in, demand. Since
the initial five-year analyses showed Ireland to be unattractive, students might recognize that they want to
restructure the Ireland alternative to make it attractive in the first five years, in case demand does not
develop fully, or is not sustained as long as projected. They should also be encouraged to consider
investment strategies that create real options (discussed in the following section on Question 4) that
could be exercised or not depending on the demand level.
On the other hand, if the growth rate is faster than expected, and total demand reaches 175 million units
sooner than 2003, the plant in Ireland, with its greater capacity, will be the most favorably affected.
Alternate Product Price Scenarios
CTI also is vulnerable to product price pressures. To evaluate this possibility, I have revised the ten-year
cash flows discounted at 10% (as shown in Exhibits TN-2 through TN-4) to reflect four alternative
product price situations:
Product price falls 5 percent per year beginning in 1999

The product prices associated with each of these scenarios are shown in Exhibit TN-8. The resulting
NPVs for Santa Clara, Waltham, and Ireland are shown in Exhibit TN-9. As shown there, the Ireland
alternative is robust to each of these sets of assumptions, except the last. However, restructuring the
investment in Ireland, as discussed below, will create options that management can choose to exercise, or
not, depending on information they acquire through time about actual prices.
Question 4: Should Tom Richards continue to develop more detailed plans for these three
alternatives? If not, which should be eliminated? Are there other alternatives that his staff should
consider? If so, what are they?
Near the end of the discussion, it is useful to have students use what they have learned from the DCF
analysis of the three alternatives in the case to develop additional alternatives for FlexConnex capacity
expansion. The significant competitive advantages offered by the new technology proposed for the plant
in Ireland have already been discussed. However, the NPV analysis shows that the size of the investment
means that a high level of demand must be reached, it must be sustained over time, and sufficient prices
must be maintained for this alternative to be financially attractive. The large investment in Ireland was
initially driven by Ians suggestion that the economic size or scale for such a plant (meaning the size of
the plant that minimizes FlexConnex cost) was 70 million units. However, that does not mean CTI has to
build the 70-million-unit plant all at once. Perhaps CTI could break this investment into two (or more)
phases. They have clearly done this in the past, as the Santa Clara plant had been designed for future
expansion. Separating the investment into two phases has a cost; for example, if a 70-million-unit scale
truly minimizes FlexConnex cost, then a smaller-scale plant will have a higher product cost. However,
CTIs current Santa Clara facility has a notably higher product cost than the Ireland proposal (Exhibit
TN-7). Thus, it is possible that a smaller scale, new technology plant will have a product cost between
Santa Claras and that of the proposed 70-million-unit plant in Ireland. This smaller-scale plant would
achieve some cost reduction and would possess the other advantages of the new technology. With a
smaller initial investment, less time will be required until a positive NPV is achieved. CTI will be
protected if demand fails to grow as large as projected or if prices fall significantly, since management
can simply decide not to make the second half of the investment.
Students sometimes suggest another two-stage alternative: invest in Waltham first, and then expand Santa
Clara when Waltham reaches capacity. They might also suggest a two-stage investment at either Santa
Clara or Waltham to expand these plants in years 46 to increase capacity if demand reaches the levels
currently projected for the later years. These alternatives will likely have a higher NPV than that of the
originally proposed Waltham or Santa Clara investments alone, due to the additional positive cash flows
from the second stage investment. However, they do not have the advantages of locating a plant in
Europe, or adopting the new technology.
Students might suggest implementing the new technology at Santa Clara or Waltham instead of Ireland.
Such proposals should be explored, and issues related to them should be identified. Students should
consider the likely effect of these proposals on costs, revenues and NPV relative to the alternatives they
have already evaluated. What if there is not enough space at Waltham or Santa Clara to eventually reach
economic size for the new technology? If new technology is installed at Santa Clara, will it replace or
operate alongside the existing technology? If it will replace the existing technology, what are the
implications of the changeover? If both technologies will be used, what are the implications of two very
different manufacturing processes running side-by-side? Are there any incompatibilities? Do workers
have the expertise to operate both? Finally, these proposals again lack the advantages of locating a plant
in Europe.
Proposals such as those above that include multi-stage investment, locating in a new region, and/or
adopting a new technology represent the creation of a real option in capital investment (Amran and
Kulitilaka 1999; Luehrmann 1997, 1998; Ross 1995; Kester 1984; Myers 1984). Real options associated
with capital investments are analogous to financial options, for example, stock options associated with
financial instruments. An option is the right, but not the obligation, to take an action in the future after
you see how the situation develops. According to Ross (1995), in addition to its in-the-money-value (the
NPV if the investment in the project were to be made today), there are two sources of option value
associated with almost all projects. One is the option on the movement of capital costs and prices.
Specifically, if you delay investment, there is always the chance that the cost of financing will decline, the
cost of the capital investment will decline, and/or the prices of the outputs produced by this investment
will increase, thus increasing the value of the investment. Alternatively, if these costs and prices moved in
the opposite directions, decreasing the attractiveness of the investment, the fact that you had delayed
making the investment will enable you to cancel the project without investing, thus leaving you better off
than if you had invested.
The second source of option value is embedded options, or options inherent in the project itself, for
example, growth options, flexibility options, and learning options (Amran and Kulitilaka 1999).
Investments such as investing in R&D or building new facilities create subsequent opportunities that
firms may or may not take. In an uncertain world, embedded options are valuable, because they position
the firm for further profitable investment, while limiting the downside exposure. That is, as more
information is gathered, and uncertainty is reduced, the firm can choose not to invest if the new
information indicates that it will not be sufficiently profitable.
Breaking the investment in Ireland into two stages creates an option on the movement of costs and prices.
It also creates an option related to technology. The technology may evolve again, and waiting to build
some capacity gives management additional technological flexibility. But, as previously discussed, the
Ireland alternative also has the most embedded options associated with it, comprising flexibility and
learning options associated with the new technology, and growth and learning options associated with a
European presence. The Waltham plant, in contrast, offers few, if any, embedded options to exploit in the
future.
Options increase the value of the capital investment beyond the NPV of todays projected cash flows.
However, they cannot be analyzed by using a DCF framework; they require a real option framework
analogous to the financial option framework (Amran and Kulitilaka 1999; Luehrmann 1998, 1997).
Instructors who choose to develop an intuitive appreciation and understanding of real options associated
with capital investment can use the case to introduce the options approach for capital investment
evaluation.
Finally, the instructor might want to ask what Tom Richards means when he says they will be out of
capacity, and whether he could utilize the existing facility more fully to increase its output without
building a plant. Productive capacity is constrained by nonproductive capacity (setups, maintenance, etc.)
and by idle capacity (lack of orders, holidays, etc.) (Ansari et al., 1997). Actions that reduce
nonproductive capacity, such as speeding up setups, or that reduce idle capacity, such as reducing the
number of holidays during which the plant is not in operation or adding extra shifts, will increase
productive capacity. Such alternatives should be thoroughly explored before deciding to build (or expand)
the plant (Ansari et al. 1997; Brausch and Taylor 1997).
SUMMARY
Rather than the more traditional application of the NPV framework (invest or not), this case utilizes the
NPV framework early in the life of a project. The decision being made is whether and where to invest
the time and effort of the manufacturing planning staff to develop and evaluate detailed plans for various
FlexConnex capacity alternatives. In addition, the NPV framework can be used in this case not just to
evaluate alternatives, but also to shape the alternatives that are considered. These preliminary choices are
important, as they define the set of alternatives that CTI will ultimately consider as well as the set of
opportunities that will no longer be considered. Managers must balance their need not to miss profitable
opportunities with the practical reality that they do not have sufficient resources to evaluate every
conceivable alternative in depth.
The CTI case illustrates the importance of selecting an appropriate discount rate. If the discount rate is too
high, it systematically disadvantages certain types of projects. The case also shows that there may be
important considerations that cannot be quantified financially, or that the time and expense required to
estimate them with precision may be excessive. These still need to be incorporated in the analysis.
Finally, the case demonstrates that capital investments have real options associated with them. The
significance of the real options varies depending on the nature of the investment. In some instances, the
value of the options may be an important (if not the most important) source of value of the investment. If
the instructor chooses to have students vote on which alternatives to pursue, the Greenfield plant in
Ireland clearly provides the largest number of real options for CTI, comprising options associated with the
new technology as well as those associated with a European presence. The Waltham alternative, although
it appears profitable in the present value analysis, seems to be the least compelling case; it will result in a
small plant, using old technology, with high unit product cost, and few if any options to exploit in the
future. The Santa Clara expansion, despite using the old technology, at least provides possibilities of
economies of scale.
REFERENCES
Amran, M., and N. Kulatilaka. 1999. Real Options: Managing Strategic Investment in an Uncertain World. Boston,
MA: Harvard Business School Press.
Ansari, S., J. Bell, T. Klammer, and C. Lawrence. 1997. Management Accounting: A Strategic Focus: Measuring
and Managing Capacity Module. Chicago IL: Richard D. Irwin.
Brausch, J. M., and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting
(February): 4450.
Kaplan, R. S. 1986. Must CIM be justified by faith alone? Harvard Business Review (March-April): 8795.
Kester, W. C. 1984. Todays options for tomorrows growth. Harvard Business Review (March-April): 153160.
Luehrman, T. A. 1997. Whats it worth? A general managers guide to valuation. Harvard Business Review (MayJune): 132142.
. 1998. Investment opportunities as real options: Getting started on the numbers. Harvard Business Review
(July-August): 5167.
Monahan, T. F., M. J. Liberatore, and D. E. Stout. 1990. Decision support for capital budgeting: A model for
classroom presentation. Journal of Accounting Education 8:225239.
Myers, S. 1984. Finance theory and financial strategy. Interfaces 14 (JanuaryFebruary): 126137.
Ross, S. A. 1995. Uses, abuses, and alternatives to the net-present-value rule. Financial Management 24 (Autumn):
96102.
20-5 General Medical Center (Source: A. H. Ashton, R. H. Ashton, and L. H. Maines. 1998
(November). General Medical Center, Issues in Accounting Education, 13 (4), pp. 994-1003.)
(This case is based on a class project prepared by Pamela Jones and John Janes in Duke
Universitys Weekend Executive M.B.A. Program.)
Abstract: The challenge of applying standard capital budgeting techniques to the evaluation of
investments in new technology, such as computer-integrated manufacturing and biotechnology, has
received increasing attention in recent years. Because the complete set of benefits from such investments
is difficult to quantify in financial terms, capital budgeting techniques that rely on NPV as the
performance metric tend to favor investments that are less risky, shorter-term, and whose consequences
are more readily quantifiable. While this is recognized in contemporary management accounting
textbooks, there is a dearth of cases drawn from actual capital budgeting settings that pose such issues in
ways that can be addressed effectively in the classroom.
This case describes a capital investment decision that includes not only the usual considerations
encountered in new technology settings, but also entails risks involving human health and life expectancy.
Specifically, the case describes an actual decision faced by a large community hospital involving a choice
between two alternative types of cardiac imaging equipment. The two types of equipment differ both in
terms of their acquisition and maintenance costs and the accuracy with which they classify patients as
needing a follow-up cardiac catheterization. Diagnostic accuracy affects the expected future costs of
patient care. Thus, the choice between the two technologies involves a trade-off of costs and the quality of
health care provided to the hospitals patient population.
Pedagogy
If sufficient time can be devoted to the topic of capital investment analysis, the GMC case can usefully
follow a more standard case or problem set that emphasizes the calculations involved in discountedcash-flow analysis and that downplays the difficulties of both (1) estimating cash flows and (2)
incorporating nonfinancial considerations into the analysis. Moreover, if practice in the calculations is
desired, the instructor can withhold Exhibit 5 (the CFOs analysis) and have the students generate it. In
our own educational settings, however (M.B.A. and Executive M.B.A. classes), we have provided the
students with Exhibit 5 as a starting point, and have found that approach to be effective.
Evaluation of the CFOs Analysis
The analysis prepared by the CFO has both strengths and weaknesses. While the case focuses students
attention on the weaknesses, it should be pointed out that Mr. Alexander has done several things right.
He has appropriately included many of the relevant costs in his analysis and has used present value
concepts to bring the future cash outflows that constitute those costs beck to the present. In addition, he
has recognized the disparity between the seven-year life of the Thallium equipment and the ten-year life
of the PET equipment and has employed the equivalent annual cost (EAC) metric to improve the
comparability of the discounted costs of the two types of scanners.
On the other hand, Mr. Alexander has omitted from his analysis several quantitative and qualitative
factors that are essential to a complete evaluation of the two scanners. The quantitative factors include the
costs associated with the additional, unnecessary cardiac catheterizations with the Thallium scanner and
those associated with the additional patients who should have been referred for catheterization but were
not. Qualitative factors include the differential mortality outcomes of the two scanners, the possibility of
lawsuits resulting from misdiagnoses, adverse reputational effects for the hospital and its physicians, and
numerous other considerations. The remainder of the Teaching Notes evaluates such factors.
Framework for Further Analysis

It is useful to begin by pointing out an important difference between the information that is relevant to
this decision and information that is relevant to most capital budgeting decisions to which accounting or
M.B.A. students are likely to have been exposed. While the typical textbook example focuses on both
the incremental costs and the incremental revenues of one alternative vs. another, the present decision
involves only costs. The hospitals revenues, under the assumption of a strictly capitated payment system,
will be identical regardless of the type of imaging equipment chosen. Thus, the familiar net present value
calculation is not relevant here. Instead, the decision will be based on what might be called a net present
cost criterion.
Mr. Alexander has used equivalent annual cost (EAC) as the metric for comparing the Thallium and PET
scanners, in an effort to provide comparability between the seven-year life of the Thallium equipment and
the ten-year life of the PET equipment. However, he has omitted some sizable financial costs from his
analysisthe costs of misdiagnoses by the two scanners.
Before evaluating the numbers of misdiagnoses made by the Thallium and PET scanners and, therefore,
the resulting additional costs, it is useful to present a general framework for analysis. We begin by
reminding students that physicians use cardiac imaging equipment, along with other information and their
own judgment, to diagnose patients as either requiring or not requiring further examination. Patients who
receive a positive scan from the noninvasive cardiac imaging procedure, suggesting a relatively high
probability of cardiac problems, are candidates for invasive cardiac catheterization for the purpose of
making a more definite assessment. Patients who receive a negative scan, suggesting a relatively low
probability of cardiac problems, are not normally candidates for catheterization.
At this point, we like to present the 2 X 2 table shown in Panel A of Exhibit 6. It shows the four
combinations that result from crossing the diagnosis of a patients diseased or normal state with his
or her actual health state. We emphasize that the upper-left and lower-right cells entail correct diagnosis,
whereas the upper-right and lower-left cells involve erroneous diagnoses (labeled False Positives and
False Negatives, respectively).
This is an excellent point to review the notions of sensitivity, specifically, and disease prevalence in the
patient population (or base rate), as well as the size of the patient population. (In this regard, it could be
pointed out that the 25 percent disease prevalent rate applies to the population of patients who actually
come to General Medical Center for evaluation, but not necessarily to the population of individuals in
GMCs geographic area.) It may also be helpful to describe how an ideal or perfect imaging technique
would sort patients into the diseased and normal classifications. Panel B of Exhibit 6 indicates that an
ideal scanner would classify 25 percent of the 1,920 patient population (480 patients) into the True
Positive cell and the remaining 75 percent (1,440 patients) into the True Negative cell, with no erroneous
diagnosis.
Costs of Additional Cardiac Catheterizations
Applying this framework to the two imaging techniques (given the information and assumptions in the
case) is the heart of the analysis. Contingency tables similar to that for the ideal scanner in Panel B of
Exhibit 6 should be prepared for each of the two scanners under consideration (see Exhibit 7). Such an
analysis reveals that the Thallium scanner results in 912 referrals for cardiac catheterizations each year,
while the PET scanner results in 528 referrals, a difference of 384 additional referrals if the Thallium
scanner is purchased. Each additional catheterization results in a cost of $2,000 to General Medical
Center.
The impact of these additional 384 catheterizations on the EACs of the two scanners is shown in Exhibits
8 and 9. For the Thallium scanners, the additional first-year cost of $1,824,000 from Exhibit 7 is simply
added to the costs considered by the CFO in Exhibit 5 of the case (and this first-year amount is increased
by 3.2 percent each subsequent year because of inflation). For the PET scanner, the additional first-year
cost of $1,056,000 from Exhibit 7 is treated in the same way.
When this new information is included, the revised EAC of the more accurate rate of the more
technologically advanced PET scanner ($2,340,182) is below that of the Thallium scanner ($2,730,697).
The relative attractiveness of these two alternative approaches to diagnostic imaging is reversed, now that
the costs of the False Position diagnoses (i.e. classifying normal patients are diseased and referring them
for unneeded $2,000 catheterizations) are considered. If the CFO had included this differential cost of the
two scanners in his analysis, he would have recommended the scanner that is favored by the physicians.
Note that Exhibits 8 and 9 use a total approach to the calculations instead of a differential approach
that would omit the constant personnel related costs. Because of the difference in the estimated lives of
the two scanners, we find it more effective to simply adjust the approach used by the CFO (Exhibit 5).
However, because capital budgeting decisions often are framed in textbooks in terms of differences
between alternative, a differential analysis for the PET and Thallium scanners is presented in Exhibit
10. Costs that do not differ between the two alternatives are excluded. The analysis is limited to
considering only the seven year time period when both scanners are operating. It shows that the
cumulative costs of the PET scanner are lower than those of the Thallium scanner from the third year
onward. If General Medical Center plans to keep it new scanner for at least three years, lower costs will
result by purchasing the PET scanner.1
At this point, it is important to remind students that strict capitation is assumed in the case; that this, the
per-patient payment that the provider receives, does not depend on the imaging technique employed.
Thus, given this assumption, it is appropriate to focus solely on the relative costs associated with each of
the two scanners. While differential fees for such procedures exist in all or even a majority of markets,
our students who are knowledgeable about health care are not distracted by the strict capitation
assumption within the context of the case. Nevertheless, it is important to make very clear to students that
if GMC receives differential fees that depend on the particular scanner used, this difference in revenues
should be included in Exhibits 8 and 10.
We also emphasize the implications of making specific revenue assumptions by pointing out to students
that, paradoxically, a strict fee-for-service environment, when viewed only from a financial perspective,
would tend to favor purchasing the Thallium scanner, as long as revenues for procedures exceed their
direct costs. The lower purchase price and lower operating costs of the Thallium scanner could result in
greater profit from the imaging procedure if it is performed using Thallium instead of PET; and the use of
the Thallium scanner would likely lead to a greater number of cardiac catheterizations than would use the
PET scanner, with even greater revenue and profit (assuming that the price charged for a cardiac
catheterization exceeds the procedure's direct costs). We are careful to emphasize to students, however,
that we are not suggesting (and do not believe) that physicians would actually choose the less diagnostic
Thallium scanner as a means of increasing revenue and profit at the expense of their patients' increased
health risks. Indeed, the case makes it clear that the physicians at GMC prefer the more advanced (and
less profitable) PET scanner.
Costs of False Negative Diagnoses
While many students will see the relevance of the differential False Positive diagnoses that result from the
two scanners, fewer are likely to realize the importance of the False Negative diagnoses, (i.e., classifying
diseased patients as normal, resulting in their not being referred for cardiac catheterization when they
should be). Focusing on the number of additional cardiac catheterizations that will be performed with
Thallium instead of PET (384) may result in the students' overlooking the cost impact of the False
Negative diagnoses. This is because the actual number of additional False Positive diagnoses that are
made by the Thallium scanner is 432 (504 - 72), not 384. This number is offset by the additional 48 False
Negative diagnoses that are made by the Thallium scanner (72 -24), resulting in only 384 additional
catheterizations with Thallium. In other Words, while Thallium incorrectly diagnoses 432 additional
normal individuals as diseased, it also incorrectly diagnoses 48 additional diseased individuals as normal.
The costs of the additional 48 False Negative diagnoses should be included in the analysis. These costs
relate to the likelihood that diseased patients who are labeled as normal and thus are not immediately
referred for cardiac catheterization probably will become even sicker at some later time and require more
extensive examination when they eventually return to the hospital (assuming they do not die first).
Consequently, the follow-up costs of treating such patients may be substantially higher than the costs
associated with immediate referral.
The case provides no information on the follow-up treatment costs of patients who initially receive False
Negative diagnoses. However, the relevance of such costs can be readily illustrated by making some
straightforward assumptions. Here, the instructor can go beyond the information in the case. We use the
following three assumptions:
Of the additional 48 diseased patients who are diagnosed as normal each year, 30 eventually return
to General Medical Center for further examination and treatment. (The remaining 18 patients might
go to some other medical center, or they might die without seeking further treatment. While these
patients represent costs to the overall system, they do not entail additional costs for General
Medical Center.)
The 30 patients who return to GMC do so at the rate of six patients per year for five years.
The cost of treating each returning patient is $4,000 (we ignore inflation here).
At steady state, 30 patients are evaluated and treated each year by general Medical centersix patients
per year from each of the previous five years. The $4,000 cost associated with each patient must be
discounted from years 1 through 5 back to year 0 (the year in which the False Negative diagnoses were
made). Since six patients will enter the system in each of the five years at a cost of $24,000 (6 x $4,000)
per year, the present value of the cost of the False Negative diagnoses in year 0 is approximately $91,000
($24,000 x 3.791, the PV annuity factor for five years @ 10%). Thus, when the additional costs of the
False Negative diagnoses are included, the Thallium scanner is even less attractive than the PET scanner.
This analysis of the differential costs of the False Negative diagnoses could be refined by recognizing that
some of these 30 diseased patients who are misdiagnosed as normal and who later return for additional
evaluation will be misdiagnosed again, thus leading to even greater costs that are traceable to the initial
misdiagnoses, rapidly becomes very small given the specificity and sensitivity values in the case.
Therefore, it probably is not useful to push the quantitative analysis to such an extent. This can be a good
point to emphasize the trade-off between the costs and benefits of more complete information in capital
investment settings.
Additional Considerations
There are many additional considerations that make this equipment purchase decision much more
complicated than that implied by the costs alone. Some of these considerations favor the PET scanner to
an even greater degree, while others may favor Thallium, and still others involve issues that are
ambiguous with respect to which scanner would be favored. Many of these additional considerations are
qualitative.
At least three additional factors that make the PET scanner even more attractive than Thallium were
overlooked by the CFO. First, his comparative analysis of the two scanners uses the most optimistic
specificity estimate for Thallium. (Recall that specificity is the proportion of normal patients who are
diagnosed correctly.) While the medical research literature reports values between 0.55 and 0.65 for
Thallium, Alexander simply uses the maximum estimate of 0.65. If he had used 0.55 instead, his original
analysis would have shown an additional 144 False Positive diagnoses with Thallium each year [(0.65
-0.55) x 1,440], which would cause Thallium to be even less attractive relative to PET. Exhibit 11
presents the analysis for the Thallium scanner using the 55% specificity rate. It shows that Thallium's
EAC using 55% is $3,044,099 compared to $2,730,697 using 65%, thus presenting an even stronger case
for the purchase of the PET scanner.
Second, the greater accuracy of the PET scanner could enhance General Medical Center's reputation for
quality patient care. It could help to develop or sustain the hospital's reputation in the community as a
"Center of Excellence." It also could impact physicians' confidence in General Medical Center as an
institution that is committed to providing cutting-edge health care, with potential positive implications for
the hospital's ability to attract quality physicians.
Finally, the potential litigation costs associated with the Thallium scanner are likely to be greater than
those of the PET scanner. Differential litigation costs could result from both the greater number of deaths
that result from the additional catheterizations with Thallium and the greater incidence of adverse health
outcomes (possibly including death) that are later associated with the additional False Negative diagnoses
made by the Thallium equipment.
In contract, some other factors that are impossible to quantify, given the information in the case, may
work against the PET scanner. For example, the greater technological sophistication of the PET scanner
may result in higher costs of training medical and support personnel in its use. Moreover, while the case
assumes a strict capitated revenue stream for General Medical Center, it may be possible under some
scenarios to pass along to patients (or their insurers) some of the additional cardiac catheterization costs
associated with Thallium.
There are, of course, many additional considerations that are relevant to the choice between the Thallium
and PET scanners. For many considerations, it is not clear whether they would favor Thallium or PET.
Examples include (1) the likelihood that specificity, sensitivity, disease prevalence rates and cardiac
catheterization costs will change over the life of the scanners, (2) the possibility that costly software or
hardware upgrades for the scanners will be needed in the future and (3) the possibility that the scanners'
useful lives will be shorter than expected (perhaps because of the appearance of even more sophisticated
equipment). The latter consideration may be particularly important, given the differential lives of the two
scanners and the current rapid pace of technological improvement of such devices. The EAC metric
implies an equivalent annual rental payment in perpetuity assuming that the relevant costs and
technological features of the two alternatives remain constant. Any technological improvements that are
specifically forecasted should, of course, be taken into account in the analysis.
Moreover, it should not be forgotten that an imaging technique is only a "decision aid" for the physician
who must interpret its output, make the final recommendation and explain that recommendation to his or
her patient. It is entirely possible that some physicians are more skilled users of Thallium and more
accurate interpreters of its results, while others are more skilled and accurate with respect to PET. This is
an excellent point at which to reiterate the critical importance of the institutional setting in which this
capital investment decision must be made.
Finally, some instructors may wish to use this case to launch a broad discussion of the different roles that
accounting systems and numbers can play in the "politics" of an organization. Such a discussion might
recognize that accounting can be used in ways other than simply providing objective information for
structured and well-accepted decision models, such as EAC. For example, Burchell et al. (1980) discuss
additional roles of accounting that are likely to be relevant in the present setting. 2 According to Burchell
et al. (1980), when organizational members disagree about goals and objectives (as could easily be the
case in today's health care environment), accounting may be used by the affected parties to promote their
own positions and/or to justify or rationalize decisions that already have been made. In the case, Dr.
Westford may already have taken the side of the physicians and decided that the more advanced
technology (the PET scanner) should be purchased. His interest in seeking a new accounting analysis of
the decision may simply reflect his desire to have an analysis that supports his decision. This approach is
referred to by Burchell et al. (1980) as using accounting as an ammunition machine or rationalization
machine. If time permits, the case can provide an effective springboard for exploring the multiple roles
of accounting in organizations, such as GMC.
Additional Reading
Bierman, H., and T. R. Dyckman. 1976. Managerial Cost Accounting. New York, NY: Macmillan.
Brealey, R., and S. Myers. 1991. Principles of Corporate Finance. New York, NY: McGraw-Hill.
Hilton, R.W. 1991. Managerial Accounting. New York, NY: McGraw-Hill.
Horngren, C. T., G. Foster, and S. M. Datar. 1997. Cost Accounting: A Managerial Emphasis. Upper
Saddle River, NY: Prentice Hall.
Kalagnaman, S., and S. K. Schmidt. 1996. Analyzing Capital Investments in New Products,
Management Accounting (January): 31-36.
Kaplan, R. S., and A. A. Atkinson. 1998. Advanced Management Accounting. Upper Saddle River, NJ:
Prentice Hall.
VanNostrand, R.C. 1998. Justifying CAD/CAM Systems: A Case Study, Journal of Cost Management
(Spring): 9-17.
References
Birnberg, J. G., L. Turopolec, and S. M. Young. 1983. The Organizational Context of Accounting,
Accounting Organizations and Society 8: 111-129.
Burchell, S., C. Clubb, A. Hopwood, J. Hughes, and J. Nahapiet. 1980. The Roles of Accounting in
Organizations and Society, Accounting, Organizations and Society 5: 5-27.
Sisaye, S. 1995. Control as an Exchange Process: A Power Control Framework of Organizations,
Behavioral Research in Accounting 7: 122-161.
Endnotes
1
Note that this differential analysis is incomplete since it implicitly assumes that the salvage value of both
the Thallium and PET scanners is zero at the end of the seventh year. This is likely to be a very reasonable
assumption, considering the rapid pace of technological improvement in medical field. However, if the
seventh-year salvage values are nonzero (and different for the two scanners), they could easily be
incorporated into the analysis. Since the PET scanner has a longer life than the Thallium scanner, its
salvage value is likely to be higher, further supporting the PET scanners purchase.
2
Useful elaborations of the Burchell et al. (1980) discussion include Birnberg et al. (1983) and Sisaye
(1995).
_____________________________________________________________________________________
EXHIBIT 6
A Framework for Analysis
Panel A: Definitions and Relationships
Actual State of Health
Diagnosis of Health
Diseased
Normal
Totals
Diseased (Positive Scan)
True Positives (a)
False Positives (b)
a+b
Normal (Negative Scan)
False Negatives (c)
True Negatives (d)
c+d
a+c
b+d
a+b+c+d
Prevalence of Disease:
(a + c)/(a + b + c + d) = 25%
Sensitivity: a/(a + c) =
85% for Thallium
95% for PET
Specificity: d/(b + d) =
65% for Thallium
95% for PET
Patient Population: a + b + c + d = (8 scans/day x 20 days/month x 12) = 1,920 patients
Panel B: Results from the Ideal of Perfect Scanner
Diagnosis of Health
Diseased
Normal
Diseased
480
0
Normal
0
1,440
480
1,440
Number of Catheterizations: 480
Total
480
1,440
1,920
______________________________________________________________________________
EXHIBIT 7
Comparison of the Diagnostic Accuracy of the Two Scanners
Panel A: Results from the Thallium Scanner
Diagnosis of Health
Diseased
Normal
Diseased
408
504
Normal
72
936
480
1,440
Total
912
1,008
1,920
Panel B: Results from the PET Scanner

Diseased
Normal
456
72
24
1,368
480
1,440
Diagnosis of Health
Diseased
Normal
Total
528
1,392
1,920

Panel C: Cost Comparison of Catheterizations for Thallium and PET
Number
Cost @ $2,000
Thallium
912
$1,824,000
PET
528
1,056,000
_____________________________________________________________________________________________
EXHIBIT 8
Revised Analysis of the Thallium Scanner Considering the Costs of Additional Catheterizations
Year Initial Cost
0
$450,000
1
2
3
4
5
6
7
Maintenance Personnel
-0$ 45,000
45,000
45,000
45,000
45,000
45,000
$108,810
112,619
116,560
120,640
124,862
129,232
133,756
Other Catheterization
$462,000
474,936
488,234
501,905
515,958
530,405
545,256
$1,824,000
1,882,368
1,942,604
2,004,767
2,068,920
2,135,125
2,203,449
Total Costs
$ 450,000
2,394,810
2,514,923
2,592,398
2,672,312
2,754,740
2,839,762
2,927,461
PV
$ 450,000
2,177,100
2,078,448
1,947,707
1,825,225
1,710,477
1,602,972
1,502,250
$13,294,179
Equivalent Annual Cost for Thallium Scanner: $2,730,697 [$13,294,179 4.86842 (PV factor for 7-year, 10%
annuity)]
_____________________________________________________________________________________________
_____________________________________________________________________________________________
EXHIBIT 9
Revised Analysis of the PET Scanner Considering the Costs of Additional Catheterizations
Year Initial Cost

0 $1,600,000
1
2
3
4
5
6
7
8
9
10
Total
Maintenance
Personnel
-0$160,000
160,000
160,000
160,000
160,000
160,000
160,000
160,000
160,000
$108,810
112,619
116,560
120,640
124,862
129,232
133,756
138,437
143,282
148,297
$564,000
579,936
596,026
612,715
629,871
647,507
665,638
694,275
703,435
723,131
$1,056,000
1,089,792
1,124,665
1,160,655
1,197,796
1,236,125
1,275,681
1,316,503
1,358,631
1,402,107
Total Costs
$1,600,000
1,728,810
1,942,203
1,997,251
2,054,010
2,112,529
2,172,864
2,235,075
2,299,215
2,365,348
2,433,535
PV
$1,600,000
1,571,646
1,605,126
1,500,565
1,402,916
1,311,714
1,226,526
1,146,946
1,072,601
1,003,139
938,233
$14,379,412
Equivalent Annual Cost for PET Scanner: $2,340,182 [$14,379,412 6.14457 (PV factor for 10-year,
10% annuity)]
_____________________________________________________________________________________
_____________________________________________________________________________________________
EXHIBIT 10
Differential Analysis of the PET and Thallium Scanners
Year Initial Cost

0 +1,150,000
1
2
3
4
5
6
7
Maintenance
-0+115,000
+115,000
+115,000
+115,000
+115,000
+115,000
Personnel
+102,000
+104,856
+107,792
+110,810
+113,913
+117,102
+120,382
+1,150,000
-768,000
-666,000
-792,576
-572,720
-817,939
-595,147
-844,112
-618,302
-871,124
-642,211
-899,000
-666,898
-927,768
-692,386
Total Costs
+1,150,000
-605,454
-473,322
-447,142
-422,309
-398,763
-376,446
-355,304
PV
+1,150,000
+544,546
+71,224
+375,918
-798,227
-1,196,990
-1,573,436
-1,928,740
Each amount represents the difference in costs between the PET scanner and the Thallium scanner (PET
cost - Thallium cost). Costs that do not differ between the two alternatives are excluded.
This analysis assumes that the salvage value of both scanners is zero at the end of the seventh year. If they
are nonzero, their present values could be included in the analysis as a reduction in the cost of the
scanners. See endnote #1 for elaboration of this point.
_____________________________________________________________________________________
20-6: Floating Investments (Source: Paul Rouse and Leigh Houghton, Instructional Case: Floating
Investments, Journal of Accounting Education, Vol. 20, No. 2 (2002), pp. 235-247.)
Purpose
The purpose of this case is to acquaint students with the complexities involved in reaching a decision
concerning investment in a capital project. The project contemplated is a marina, which is to be built on
purpose-bought land. Students enjoy this more unusual setting with its leisure and entertainment avor
and are usually enthusiastic about evaluating the project.
In analyzing the issues the student should consider:
(a) The investment decision; that is, the nature and risks associated with this type of investment.
(b) The capital investment model; that is, the investments, operating cash ows, terminal value, discount
rate, taxation, and ination eects
(c) The moving baseline concept; that is, the changing nature of the market that this investment will
serve.
(d) The risks involved in this type of project and the ways in which these risk factors can be managed.
Teaching Strategies
This case has been used in both large and small classes. In both situations the student is expected to have
read the case in advance and to have prepared an outline of an answer. In a large class (up to 250
students), students benet by the lecturer talking through the various analysis steps. However, there is
enough challenging material in the case to provoke lively discussion on a number of the concepts. In
small classes, the case works well with the students split into groups of about six with a facilitator to
ensure that they progress successfully through the material. At the end of the group work the students
benet by a class discussion of the concepts covered.
Concepts covered
The investment decision
Although the fundamental question to be addressed in an investment decision is whether the returns from
an investment exceed its costs, the nature and risks vary considerably from one project to another. The
marina project is extremely seductive as evidenced by Jims enthusiasm and it is easy to forget that
similar evaluation criteria need to be applied to this project as to a more mundane project.
Three questions can be addressed:
(a) The size and risk of the investment. The capital outlay for this project is large. The nature of this
type of venture, which requires dredging of the seabed to provide sucient draft for the boats and
the constant maintenance of sea walls and pontoons, may mean that the risk is dicult to quantify.
(b) The complexity of the venture. Will the service facilities and technological support oered by this
marina be appropriate over its lifetime or is it likely that the requirements of boat owners may
change over the life span of the marina? For example, boat owners might require access to waste
disposal systems or the ability to access computer facilities to provide weather information.
(c) The time frame for the venture. This venture is expected to run for a period of 22 years including
construction. Therefore establishment of the attributes of the after tax cash ows becomes more
critical. The variability of these cash ows over a long time period will depend on the needs of the
consumers and the level of service provided by the marina owners.
The capital investment model

There are a number of models that can be used for making capital budgeting decisions. Those not
requiring the use of discounted cash-ow techniques are payback and the accounting rate of return.
Models that use discounted cash-ow techniques are IRR and NPV. Students should be encouraged to
discuss the benets and drawbacks of the application of each of these techniques (see Atkinson, Banker,
Kaplan, & Young, 1997; Brealey, Myers, & Marcus, 1999; Horngren, Foster, & Datar, 1999) and justify
why NPV should be chosen as the most appropriate method for use in this situation.
Assessing the capital investment model requires consideration of all of the inputs to the model.
(a) Investment in the project
The initial outlays are set out in the construction contract, but capital outlays that might be required later
in the projects life are not covered. With an investment that is exposed to the vagaries of the weather, as
is this project, there is a possibility that signicant upgrades or additional maintenance will be needed
before the end of the project life. An assessment of the project should also consider the intangible benets
that a project of this nature may generate to the operators (in terms of reputation and prole) and berthholders; for example, quality of mooring, safety, maintenance and stores provision. There are also
opportunities for additional revenue streams through infrastructural development, including restaurants,
bars, and haul-out facilities. Other opportunities can arise through the encouragement of major regattas
and high prole races to be based around the marina; for example, the Americas Cup. Of course, hosting
these types of events would require additional investment.
(b) Operating cash ows
Operating cash inows from this project come primarily from rents paid by boat owners. In establishing
an appropriate annual rental, consideration should be given to the supply of marinas in the area and the
expected demand that will be placed on this new resource. If there are other marinas available or pending,
then the pricing of the service may need to be based on a strategy of either low cost to the renter or
product dierentiation.
While not necessarily a public sector setting, the case provides a plausible scenario where there are no
established market prices. Information on minimum revenues forms an important part of the overall
project evaluation. In this particular case, the minimum price must pass a reasonableness test in
comparison with that charged by the local Port Authority.
Operating cash outows may be more dicult to quantify because of the nature of the asset. Repairs and
maintenance could be high if the marina is constantly pounded by the sea. Might it be necessary to insure
against a major weather disaster (e.g. a hurricane)? If so, this would need to be factored into the
expenditure.
(c) Terminal values
Identifying and quantifying the terminal value of any investment is important. The terminal (or horizon)
value represents the cash value of the investment at the end of the period used in the capital budgeting
model. This is of particular importance in situations involving investments expected to have a long life.
While the conventional assumption is that the discounting process reduces future cash ows or values to
an extent that they can be ignored or assumed to be zero, in practice this is often not the case. For
example, Copeland, Koller, and Murrin (2000, p. 275) report that the horizon value for a company in the
tobacco industry accounts for 56% of the total company value, in the sporting goods industry it is 81%,
for the typical skin care business the gure is 100%, and for a high tech company 125%. This increase in
value can be particularly rapid when the resource forms part of a larger development (e.g. a high-class
land subdivision).
Jim has assumed that the marina itself is not expected to have any commercial value but the land it
occupies will have value. The diculty in establishing a value for this land in 22 years time hinges on a
number of variables that are not only a reection of the increase in ination over a period of time but
could also represent economic conditions of the time, the desire of buyers to want land in that area, or
changes in a district scheme covering land use. It is also worth mentioning that students often overlook
demolition costs when discussing terminal values.
The marina is assumed to have zero value after 22 years. However, provided it is well maintained, there is
likely to be a substantial terminal value at this time. The instructor may wish to add some alternative
approaches to determining the terminal value (see Copeland et al., 2000 for a more in-depth discussion).
The rst alternative (liquidation approach) is to set the terminal value equal to an estimate of the proceeds
from the sale of the assets of the marina, after paying o liabilities. This will normally be considerably
lower than the value of the marina as a going concern. Although the 4% tax rate could be used implying a
useful life of 25 years for the assets, this excludes $2,400,000 that was not depreciable for tax purposes.
Assuming that this latter amount had no future value, the estimated terminal value at the end of 22 years
would be $1,920,000(1.06)20=$6,157,000. (It could be argued that this amount should be spread pro-rata
over the rst three years and then adjusted for ination.) Taxation on the depreciation recovered would
then need to be determined and the net amount discounted using 16.6%.
A second alternative (replacement-cost approach) would set the terminal value on a continuing value
basis. In this approach, the marina would be valued at replacement cost after 22 years. In the absence of
any specic price ination, the $12 million construction costs could be indexed at the ination rate of 6%
and discounted back using 16.6%. A shorter method would discount $9,604,185 (being the present value
of construction costs over 3 years) using the real discount rate of 10% for year 22.
A third alternative, which is a variation on the second above, would be to assume that the marina will
carry on indenitely and repeat the roll-overs three to four times. There is not much point going beyond
80 or 90 years as the discount rates are close to zero.
A fourth method, which would be applicable if we knew what the market rentals should be, would be to
use a steady state model at year 22. A simple version of this model is as follows:
PVH = (1 + g) CFH/(k - g)
where PVH is the terminal or continuing value, g is the growth rate (< k), CFH are the annual cash ows in
the horizon year, and k is the discount rate. Since the unknown factor in this case is the price, we cannot
use this formula. Further variations on this model are covered in Copeland et al. (2000) and Levin and
Olsson (2000).
(d) Discount rate
The discount rate chosen should reect the risk of the investment taking into consideration some of the
examples mentioned above and the rms cost of capital. Given that the discount rate is usually nominal
and includes ination, the cash ows should be adjusted to compensate for this factor (Carsberg & Hope,
1976). Mixing nominal with real is a technical error that is probably more commonplace than one would
imagine (e.g. Wilmington, Tap, & Die, 1985). Given this confusion, further explanation is provided below
or students can be referred to Carsberg and Hope (1976) or Zimmerman (2000).
In the absence of ination, a rational individual will prefer a dollar today to a dollar tomorrow. The reason
for this preference is the interest that could be earned on this dollar between today and tomorrow. Let r
denote the real interest rate, which is the rate of interest that would occur if there were no ination. Note
that this rate comprises a risk-free rate of return plus a premium for risk depending on how the dollar was
invested.
If ination is present, then a rational individual will again prefer a dollar today not only because of the
interest that could be earned but also because of the loss in purchasing power if the dollar is received at a
future date. If ination is i percentage per year, $1 today will need to be increased to $1(1 + i) in a years
time to buy the same quantity of goods. For example, if annual ination is 5%, buying the same $1 bundle
of goods today will cost $1.05 in a years time. Therefore, our rational individual will require
compensation for (1) interest and (2) ination to delay the use or consumption of the $1 for any period of
time. Assuming a period of time of one year, the nominal interest rate m is
1 + m = (1 + r) (1 + i)
the cost of capital for Floating Investments is 16.6%, calculated after taking ination of 6% into account.
Substituting this information into the earlier equation
1.166 = (1 + r) (1.06)
and solving for r provides a real rate of return of 10%.
In general, the cost of capital or discount rates that rms use for capital budgeting purposes are derived
from the market and will incorporate an allowance for ination. In contrast, the cash ows estimated for a
project may inadvertently not include any allowance for general price changes (i.e. ination). Failure to
adjust these cash ows will bias the project evaluation since ination is included in the discount rate but
not in the cash ows. This is shown below where CF t denotes the annual cash ows in real terms (i.e. no
adjustment for ination has been made) and n denotes the terminal year.
PV
CFt
(1 i )(1 r )
i 1
[wrong model]
The dierence can be easily seen in the following where annual cash ows are adjusted for ination.
n
PV
t 1
CFt (1 i ) t
[(1 i)(1 r)]t
[correct model]
The general rule is that nominal cash ows should be discounted using a nominal rate or real cash ows
should be discounted using a real rate. Mixing real with nominal will lead to erroneous results.
One question that Emma could consider is whether the risk associated with holding the land over the
period of the investment is equivalent to the risk involved in the marina development. How would
dierent risk factors be incorporated into the calculations?
The moving baseline concept
Frequently, capital investment decisions are based on the status quo being maintained with respect to
competitors in the same market. The moving baseline concept suggests that competitors and the market
may move concurrently with the investment being undertaken (Howell & Soucy, 1987). This moving
baseline should be then factored into the investment decision. It may be that the investor needs to proceed
with an investment that demonstrates a negative net present value in order to maintain current market
position. The cost associated with not investing is reected in loss of market share and ultimately loss of
prots.
In this instance, it may be necessary to build the marina to ensure that the company can take advantage of
events associated with the marina; for example, the Americas cup.
Risk management
Risk tends to be managed in a capital investment decision by adjusting the cost of capital or by altering
the forecast cash ows to reect conservative estimates. In this project, when adjusting the cost of capital
for risk, management would need to look at the expertise that this company has acquired through its
successful investments in similar types of projects. This is not a new type of venture for this company.
The risk should also be balanced against the remaining portfolio of investments that the company already
holds, i.e. is the company able to spread its risks over a wide portfolio?
Numerical analysis
The numerical analysis is set out below in three parts: part A determines the investment outlay; part B
calculates the operating cash ows net of depreciation that the rental needs to cover, and part C calculates
the minimum rental required. Workings (W) are provided after part C.
A. Non-Operating Cash ows
PV (Oct/2001)
(a) Land:
Cost
Sale (W1)
(b) Construction:
2001 (Year 0) $1,200,000
2002 (Year 1) $4,800,000
2003 (Year 2) $4,800,000
2004 (Year 3) $1,200,000
- $350,000
+ $42,996
- $1,200,000
@ 16.6% (W 2)
- $ 8,404,185
(c) Tax saving on scrapping of construction in 2023 (W3)
+ $32,727
Net non-operating cash ows
- $9,878,462
B. Operating Cash Flows

(a) Tax saving re depreciation (Annualyears 322):
50% x 4% x 80% x $12,000,000 = $192,000
(Tax rate x depreciation rate x depreciable cost)
PV of $192,000 (Y3-Y22) @ 16.6% (W4)
+$811,308
Note: these are nominal cash ows and therefore the nominal rate is used.
(b) Rentals & maintenance (less taxes thereon):
(R$60,000) (150%), years 322
PV annuity factor = 7.0360 (W5)
PV = 7.0360 (R$60,000) (50%) =
+7.0360 (0.5 R $30,000)
Note: these are real cash ows and therefore the real rate is used.
C. Rental Calculation
PV of Cash Inflows = PV of Cash Outflows
7.0360 x (0.50R - $30,000) + $811,308
0.50R - $30,000
R
R = $2,637,360 x (1.06)3
=
=
=
=
$
$
$
$
9,878,462
1,288,680
2,637,360 (@ Oct/2001)
3,141,138 (@ Oct/2003)
Note: The Oct 2001 rental is inated for three years at 6% to restate it in Oct 2003 dollars.
Calculation of boat-metres:
Type
A
B
C
Length
1218
812
68
Midpoint
15
10
7
Number
50
300
150
Metres
750
3000
1050
4800
Annual rental per metre (year to 31 October 2004)=$3,141,138/4,800=$654.40 Rental for 10 m

yacht=$6,544.00
Note: this assumes that all berths are leased. If this is not likely, the above calculations should be
revised. This could be extended to a simulation exercise using a spreadsheet as outlined in Rouse
(1992).
Workings
W1
Land: est. value in year 0

est. value in year 22
=
=
=
=
$350,000
$350,000 x (1.06)22 (escalated at inflation rate)
$350,000 x 3.6035
$1,261,238 (sale price)
PV of $1,261,238 discounted at 16.6% (cost of capital)

= $1,261,238 x (1.166)-22
= $1,261,238 x 0.0341 =$42,996
Note: Calculation of (1.06)22 on Lotus: + A1 ^ 22 with 1.06 in Cell A1
Similarly, (1.166)-22: +B1 ^ -22 with 1.166 in Cell B1
The commands are the same in Excel
Simpler alternative:
Escalate at ination rate (1.06)
Discount at nominal rate (1.166)
Eectively discount at real rate:
(1+r) = (1+m)/(1+i) = (1.166)/(1.06) = 1.10
i.e., the real rate, r = 10.0%
PV
= $350 000 x (1.10)-22 = $350,000 x 0.1228 = $42,996
W2 Construction Cash Outows:
Discount factor
@ 16.6%
0.8576
Discounted
Cashow
$4,116,638
Year
Cashow
$4,800,000
$4,800,000
0.7355
$3,530,565
$1,200,000
0.6308
$756,982
$8,404,185
Note: Calculation of above in Lotus: @NPV(0.166,A1..A3)

Excel: =NPV(0.166,A1:A3)
W3
Construction cost (end year 2) =

$12,000,000
Tax value=80% x $12,000,000 =
$9,600,000
Depreciation 20 years @ 4% per annum =
7,680,000
Balance undepreciatedwritten o for tax purposes =
$1,920,000
Tax saving (50%; year 22)
960,000
-22
PV of tax saving = $960,000(1.166) =$960,000 x 0.0341=
$32,727
W4
Tax saving re depreciation remains constant at $192,000 annually (years 3 to 22)

Discount rate is 16.6% (nominal rate, not real rate)
PV = $192,000 x (annuity for 22 yearsannuity for 2 years)
= $192,000 x (5.81873 - 1.59317) =$192,000 x 4.22556 = $811,308
Note: Calculation of $1 annuity @ 16.6% for 22 years on
Lotus: @PV(1,0.166,22)
Excel: =-PV(0.166,22,1)
W5
Rentals, maintenance and taxes thereon:

Escalate at ination rate of 6%
Discount at monetary rate of 16.6%.
Eective discount rate (see W1 above) is 10%
In real terms, rentals and maintenance (and taxes thereon) are constant and can be regarded as an
annuity at 10% from year 3 to year 22.
PV factor = (8.7720 - 1.7360) = 7.0360
References
Atkinson, A. A., Banker, R. D., Kaplan, R. S., & Young, S. M. (1997). Management Accounting
(2nd ed.). New Jersey: Prentice Hall.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (1999). Fundamentals of Corporate nance (2nd
ed.). Boston: Irwin/McGraw-Hill.
Carsberg, B., & Hope, A. (1976). Business investment decisions under ination. UK: The
Institute of Chartered Accountants in England and Wales.
Copeland, T., Koller, T., & Murrin, J. (2000). Valuation: measuring and managing the value of
companies (3rd ed.). John Wiley & Sons.
Horngren, C. T., Foster, G., & Datar, S. M. (1999). Cost accounting: a Managerial Emphasis
(10th ed.). New Jersey: Prentice Hall.
Howell, R. A., & Soucy, S. R. (1987). Capital Investment in the New Manufacturing
Environment. Management Accounting. November, 2632.
Levin, J., & Olsson, P. (2000). Terminal value techniques in equity valuationimplications of
the steady state assumption. Working paper series in Business Administration, Stockholm
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hhbhastba2000_007.html.
Rouse, P. (1992). Constructing Monte Carlo Simulations in Lotus 12-3. Journal of Accounting
Education, 11, 113132.
Wilmington Tap, & Die. (1985). Harvard Case Study 985124.
Zimmerman, J. L. (2000). Accounting for decision making and control (3rd ed.). Boston:
Irwin/McGraw-Hill.
Teaching Strategies for Articles

20-1: How Forest Product Companies Analyze Capital Budgets
This article presents the result of a survey on the uses of capital budgeting techniques by forest product
companies. Capital budgeting for this industry has become more challenging and riskier because of
increasing competitiveness and government and environmental pressures. The survey shows that 1) there
has been a significant increase in the use of the DCF method for all capital investment decisions, 2)
quantified risk analysis has taken on increased importance, 3) more firms implement post audit
procedures as a way to both monitor and control their capital investment, and 4) other procedures such as
breakeven analysis, probability analysis, and decision tress are coming into use as relevant capital
budgeting methodologies.
Discussion Questions:
Question 1: The survey result shows that more firms use one or more discounted cash flow methods in
evaluating timber-related investments. However, more firms use payback period to evaluate plant and
equipment purchases. What might be the reasons for these differences?
The survey found the 76% of the firm used a DCF method for time-related investments compared to
55% of plant and equipment purchases. The reason might be that time-related investments are longer
than investments in plants and equipment. It is much more important to take time value of money into
consideration for long investments.
Question 2: List changes in the uses of capital budgeting techniques over the years.
Among the changes over the years observed in the survey are:
1. A much higher percentage of the forest products firm uses one of the discounted cash flow
methods as a primary capital budgeting technique in 1998 (64%) than in 1977 (44%)
2. The payback period method is still the dominant secondary technique.
Question 3: List some of the methods for adjusting risks in capital investments.
Common methods for adjusting capital projects for risk are adjusting the cost of capital used in
discounting cash flows or as the cutoff rate, adjusting the project life, and conducting sensitivity
analysis to determine the allowable ranges of variation of expected revenues or costs.
Question 4: What is a post-audit? How do forest product companies conduct post-audits?
A post audit compares the actual results of a capital project with the original forecasts that were used
in making the capital investment decision.
The survey shows that post audits seem to be the general practice in all but the smallest forest
products companies. Post audits typically were conducted between six months to one year after
projects were fully operational. For large projects, post audits were mandatory with the results
reported to the board. Most firms conducted post audits on only the first year results.
20-2: How ABC Was Used in Capital Budgeting

This article presents a case study on the difference that ABC makes on the investment decision of a new
project. A business forecast signaled Go to an interactive TV project, but the ABC analysis said, Stop.
The article discusses the utilization and limitations of activity-based costing (ABC) in capital budgeting
including capacity to predict operating and capital costs, benchmarking model and steps in using ABC in
capital investment project.
Discussion Questions:
Question 1: What is the general business case approach to capital budgeting?
A general business case approach generally is done at a broad strategic level with few supporting
level. Figure 1 in the article provides an overview of the business case approach to capital budgeting.
The process starts with broad market assumptions concerning the market size of the total market and
the expected market share of the firm. These assumptions are then converted into general projections
of revenues with few supporting details. Variable and fixed costs also are projected using general cost
assumptions without much detailed, if any, cost analyses.
Question 2: How does an ABC model approach to capital budgeting differ from the general business case
approach?
The ABC model approach started with forecasts based on detailed benchmarked data. Using
benchmark assumptions, the ABC approach developed a deployment schedule and a transaction
volume schedule. Both schedules are then used to help generate the revenue, cost, and capital
assumptions and projections. Figure 2 provides an overview of the ABC approach to capital
budgeting.
Question 3: What are the roles of value chain in capital budgeting?
The specification of value chain allows identifications of major activities in each of the business
processes. This allows the firm to gain a better capital budgeting by allowing the firm to identify
resource consumption profiles and cost drivers for each of the major activities.
Question 4: List advantages and limitations of an ABC approach to capital budgeting.
Among advantages of an ABC approach to capital budgeting are:
1. The pro forma analysis of the business processes and activities with linkages to revenue and cost
structures provided critical information for the final analysis.
2. The ABC analysis can help clarify marketing strategies.
However, the ABC approach can be more costly and time-consuming.

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Chapter 20

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

an,i = 1.008(30 - n)12

In one algebraic statement, at age 52, Saver has:

{[1,640(1.05) 640]( 1.0 67 1)/0.0 67)(1.0 83

At age 54, Saver has $826,621 x 1.008324 $1,000,212.

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Status quo: Model

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

ACE does not introduce Model Z

ACE introduces Model Z at end of Year 1

ACE introduces Model Z at end of Year 2

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Net Cash Flow from

Net Cash Flow from

Net Cash Flow from

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Net Cash Flow from

Net Cash Flow from

Net Cash Flow from

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Net Cash Flow from New

Net Cash Flow from New

Net Cash Flow from New

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

The Option Value from Waiting

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

TABLE 2: Present Value Computations

Choice B: Accelerated Development

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008

Blocher, Stout, Cokins, Chen: Cost Management, 4e

The McGraw-Hill Companies, Inc., 2008