CHAPTER 21

INFORMATION FOR CAPITAL EXPENDITURE

DECISIONS
ANSWERS TO REVIEW QUESTIONS

21.1 Capital expenditure can have an impact on a firm’s competitiveness, as it includes the purchase
of manufacturing technology and other significant assets. This may allow the firm to manufacture
products of higher quality than competitors, to better meet the changing needs of customers. The
purchase of new plant or premises may provide firms with an increased capacity to serve their
markets and customers and operate at an advantage over competitors. There are regular
examples of this in the business press. The purchase of advanced information technology and
communications systems may provide organisations with superior information processing
capabilities, data management systems and reporting systems, which can provide more effective
and efficient management systems. This can lead to better strategic decisions and assist
organisations to compete more effectively.

21.2 In the chapter Emmanuel, Otley and Merchant’s six stages in the capital expenditure process
were presented.
1 Generate projects: they should be consistent with strategic plans and comply with the
guidelines drawn up to evaluate capital expenditure proposals.
2 Estimate and analyse the project’s cash flows: the cash flows should extend over the life of
the project, and the analysis will use one or more of the techniques covered in the chapter.
3 Progress the project proposal through however many levels of management required to
approval: the larger or more risky the project, the higher the level of management approval
needed. Advancing through the levels of management may subject the proposing
(initiating) manager to a political process since the project will be competing for scarce
resources with the proposals of other managers.
4 Analysis and selection of the projects: substantial projects will need corporate approval
and will have reached this stage after lengthy ‘promotional’ activity.
5 Implement project: the natural step after approval.
6 Post-completion audit: at least 12 months after implementation, a full evaluation of the
project, its effectiveness (i.e. whether it is achieving the objective for which it was
designed) and any other outcomes should be made. The audits may also indicate how
effective the project design and evaluation system is.
Students should show a general understanding of these logical stages rather than precisely
copy the overview in the chapter. In answering this question it is not the number of stages that
are important—different authors and textbooks differ in the number of identified stages—it is
important that the full process is covered.
The management accountant will play a major role in stages 2 and 6, and may also be an
important participant in stage 3.

21.3 In a discounted cash flow (DCF) analysis, all cash flows occurring over the life of an investment
are discounted to their present value. The discounting process makes cash flows occurring at
different points in time comparable in an economic sense. The two common methods of
discounted cash flow analysis are the net present value method and the internal rate of return
method.
Under the net present value method, the future cash flows of a project are discounted to the
present, using a discount rate. Under the internal rate of return method, the rate of return of a
project is calculated by considering the future cash flows and the discount rate when net present
value is set to zero.
21.4 This statement is false. As the discount rate increases, the present value of a future cash flow
decreases. A higher discount rate means a higher required return on funds that are invested
now. If funds invested now can earn a greater return, it is even more important to have the funds
now, instead of in the future, than it would be if the rate of return were lower. Therefore, the
greater the discount rate, or rate of return on invested funds, the lower will be the present value
of any future cash flow.
21.5 Two advantages of the net present value method over the internal rate of return method are as
follows:
 If the investment analysis is done by hand, it is easier to compute a project’s NPV than its
IRR.
 Under the NPV method, the analyst can adjust for risk. This risk adjustment can be done by
using a higher discount rate for later or more uncertain cash flows than for earlier or less
uncertain cash flows.

21.6 The NPV and IRR methods are based on several assumptions:
 All cash flows are treated as if they occur at year end.
 Cash flows are assumed to be known with certainty.
 The IRR assumes that any cash inflows over the life of the project are reinvested at the
same rate as the project’s internal rate of return.

21.7 The net present value method and the internal rate of return method may yield different rankings
for investments with different lives because they make different implicit assumptions about the
reinvestment of funds generated from the investment. Under the net present value method, cash
flows are assumed to be reinvested at the rate used to discount the cash flows (the firm’s
required rate of return) in the NPV analysis. In the internal rate of return method, the cash flows
are assumed to be reinvested at the internal rate of return.
21.8 Managerial actions that could occur over the life of the CT scanner include:
 the replacement of the CT scanner before the end of its useful life (say after 4 years),
due to the emergence of new high speed and lower cost scanning technologies
 the purchase of a new CT scanner after year 3 with a larger capacity, due to an increase
in government subsidies for CT scans which leads to an increased demand for CT scans
 the reinstallation of the CT scanners into a new location following a major refurbishment
of the hospital
 the abandonment/scrapping of the CT scanners due to a hospital decision to outsource
all radiography and scanning services.
For each managerial action there needs to be estimates of the probability of the particular events
that could lead to the action, as well as cash inflows and cash outflows.
21.9 The payback method is used because (1) it is simple to calculate and understand; (2) it provides
a rough screening tool for investment projects; (3) it allows cash-poor firms to identify projects
that will recoup initial investments quickly; and (4) it provides some insight into the risks of a
project.
21.10 The accounting rate of return is calculated as the average annual profit that results from the
project divided by the initial investment. Thus, it is similar to ROI. It is difficult to relate this to the
IRR, as they are measures that encompass totally different assumptions. The ARR is based on
accounting profit and is calculated for each year. The IRR provides a single return based on cash
flows over the years of the project, and assume that excess cash flows are reinvested at the IRR
rate. In some cases, the ARR may be higher and in some cases lower than the IRR.
21.11 This statement highlights one of the difficulties of measuring managerial performance based on a
business unit’s ROI, but evaluating new projects based on NPV or IRR over the life of the
project. For projects that do not generate accounting profits in the early years of a project, there
 is a disincentive for managers to campaign in support of what otherwise may be a highly
desirable project. Dealing with the conflict may require a de-emphasis on the use of accounting-
based incentive systems.
21.12 The after-tax amount of an increase in sales or expenses is calculated by multiplying the sales
revenue or expenses by one minus the tax rate.
21.13 Two examples of cash flows not included in the income statement are an investment allowance
and proceeds of sale of an asset. The investment allowance is not included as it is not a revenue
or expense. It is merely an incentive that is allowed to decrease the tax paid. The proceeds of
sale are not included in the income statement as it is not a revenue or expense. Rather the
proceeds are recognised as part of the profit or loss on sale of an asset and this is in the income
statement.
21.14 Under the diminishing value depreciation method, the depreciation expense for an asset is larger
in the earlier years and lower in the later years than it would be under the straight-line method.
This is advantageous to the business, because the larger depreciation charges in the earlier
years results in reduced cash outflows for taxes in the earlier years. Because of the time value of
money, it is better to have the larger reductions in cash flows for taxes in the earlier years,
instead of the later years.
21.15 This is false. The profit or loss on the sale of an asset is not a cash flow, but it does result in a
reduction or increase in taxation paid. Thus, it is relevant to capital expenditure analysis.
21.16 In a post-completion audit of an investment project, the management accountant gathers
information about the actual cash flows generated by the project and compares these with the
cash flows projected in the capital budget proposal. Then the project’s actual NPV or IRR is
calculated. Finally, the projections made for the project are compared with the actual results. If
the project has not met the projections, an investigation may be made to consider the reasons.
Was the estimated life too short? Were cash flows too optimistic? Were some important cash
flows omitted?
Not all businesses undertake post-completion audits of their capital expenditure decisions. One
reason is that it is difficult to isolate the actual cash flows that relate to specific projects. Another
reason is that there may be little incentive for management to review the quality of the initial
analysis and subsequent implementation of the project. However, in situations where there are
massive cost overruns or other negative outcomes then the audit can provide valuable learning
for management.
21.17 The companies mentioned in the ‘Real life’ have invested in new technologies to improve their
competitive position and productivity. Traditional capital expenditure analysis may not always
capture strategic advantages, as converting these factors into future cash flows can be difficult.
In particular, there is an implicit assumption in many capital expenditure analyses that if a project
does not proceed then ‘things will stay the same’. However, sometimes not investing in a project
can lead to a loss in competitiveness and hence a reduction in future sales and profits.
21.18 Its clear from the ‘Real life’ about Qantas that a strategic priority for the firm is to use the latest
technology in the belief that their client base prefers to fly in the newest aircraft models. If Qantas
slips behind their competitors in this regard they are likely to lose regular passengers to other
airlines. According to their CEO: ‘This company’s greatness is based on being the first with the
best aircraft.’ As was found with the new A380, this approach may lead Qantas to run the risk of
being associated with flaws in the new design, since they invest in aircraft that do not have an
established safety record.
Qantas must have made strategic decisions with regard to the extent to which their services
cover the extra long-haul flights—how far they must fly and how often they will fly those routes.
This determines the type of aircraft they require and how many they require.
In deciding the seating capacity and configuration, which we see are very important in the order,
Qantas would have been consistent with their strategy with regard to the balance between first
class, business and economy on their flights. In recent years Qantas seems to have targeted
business class travellers far more now than a decade ago and configure their long-haul aircraft
such that they provide business class travellers with flat bed convertible seats. In addition they
introduced premium economy seats for people who want a better seat than economy but without
the excessive cost of business class.
21.19 Sometimes it is assumed that the current cash flow situation will be maintained if a particular
investment does not take place. However, this ignores the effect that not investing can have on
cash flows. There may be a reduction in cash flows if a project does not proceed, and this is the
appropriate baseline against which to compare future cash flows from a project. Not investing
may result in a loss of competitive advantage for a business and, thus, a reduction in cash flows.
For example, if competitors have acquired certain high-tech equipment, a company may have
 little choice but to follow, because not investing may cause a loss in market share and profits.
21.20 NPV is still a valid method for evaluating projects of strategic significance. However, attempts
should be made to include seemingly ‘non-quantifiable’ factors into the analysis, or greater
weight should be placed on strategic aspects of the investment.
SOLUTIONS TO EXERCISES

EXERCISE 21.21 (15 minutes) Net present value: local council

Acquisition cost of site (time 0) $(234 000)
Preparatory work (time 0) (88 080)
Total cost at time 0 (322 080)
Present value of annual savings in operating costs: ($48 000  7.360*) 353 280
Net present value $31 200
* From Table 4 in the appendix; r = 0.06 and n = 10.
Based on the financial analysis, the board should approve a new landfill, because the project’s net
present value is positive.

EXERCISE 21.22 (15 minutes) Internal rate of return: local council

Acquisition cost of site (time 0) ........................................................................ $234 000

Preparatory work (time 0) ................................................................................   88 080

Total cash outflow at time 0 ............................................................................. $322 080

Annuity discount factor initial cash outflow

associated =
 with the internal rate of return annual cost  savings
= $322 080 / $48 000

= 6.710

Find 6.710 in the Year-10 row of Table 4 in the Appendix. This annuity discount factor falls in the 8 per
cent column. Thus, the project’s internal rate of return is 8 per cent. Based on the financial analysis, the
board should approve the new landfill because the project’s internal rate of return is higher than the
hurdle rate of 6 per cent.

EXERCISE 21.23 (15 minutes) Net present value: not-for-profit organisation

Cost of new water tank (time 0) $(14 125)
Present value of annual savings: ($2500  7.360*) 18 400
Net present value $4 275
* From Table 4 in the Appendix; r = 0.06 and n = 10.
The management committee should approve the new water tank, because the project’s net present
value is positive.
EXERCISE 21.24 (15 minutes) Internal rate of return: not-for-profit organisation
Annuity discount factor associated with the IRR
:
initial cash outflow
= annual cost savings
$ 14 125
= $ 2 500

= 5.650
Find 5.650 in the Year-10 row of Table 4 in the Appendix. This annuity discount factor falls in the 12
per cent column. Thus, the project’s internal rate of return is 12 per cent. Based on the financial
analysis, the management committee should approve the new water tank, because the project’s
internal rate of return is greater than the hurdle rate of 6 per cent.

EXERCISE 21.25 (15 minutes) Net present value with different discount rates: theatre
company

Annuity
Discount discount Annual Acquisition Net present
rate factor* savings cost value†

8% 5.747 $27 000 $129 750 $25 419

10% 5.335 $27 000 $129 750 $14 295

12% 4.968 $27 000 $129 750 $4 386

14% 4.639 $27 000 $129 750 ($4 497)

16% 4.344 $27 000 $129 750 ($12 462)

*
Table 4: r = rate in left column, n = 8.
†
Net present value = (annuity discount factor  annual savings) – acquisition cost.
Notice that the net present value in the right-hand column declines as the discount rate increases. The
project will not yield a positive return if the discount rate is 14 per cent or 16 per cent. If either of these
rates reflect the cost of capital, then the theatre will need to find more cost savings or purchase a
cheaper lighting system.
EXERCISE 21.26 (20 minutes) Payback period; net present value; even cash flows:
bank
initial investment
1 Payback period = annual after-tax cash flow

$513 000
= $110 000 = 4.664 years
2 Net present value analysis:

Discount rate

8% 10% 12%

Present value of after tax

savings:

$110 000  5.206 572 660

$110 000  4.868 $535 480

$110 000  4.564 $502 040

Initial investment (513 000) (513 000) (513 000)

Net present value $59 660 $ $22 480 $ (10
960)

3 Conclusion: The automatic teller machines are a sound financial investment if the discount rate is
8 or 10 per cent, but not if it is 12 per cent or higher The payback period criterion fails to account
for the time value of money and provides a different assessment of the project. If management
uses the payback method, the investment will be acceptable if the required payback period is
4.66 years or less. This is likely as the estimated life of the project is 7 years.

EXERCISE 21.27 (30 minutes) Payback period; net present value; uneven cash flows:
publishing company
1 Payback period = 3 years
The accumulated incremental cash flows total $165 500 in the first three years, as the following
table shows ($50 000 + $55 000 + $60 500), which equals the initial investment in advertising of
$165 500. (See the following table.)

2 Incremental Incremental Incremental Discoun Present

t

Year revenue expense cash flows factor value

1 75 000 25 000 50 000 0.926 46 300

2 82 500 27 500 55 000 0.857 47 135

3 90 750 30 250 60 500 0.794 48 037

4 99 825 33 275 66 550 0.735 48 914

5 109 808 36 603 73 205 0.681 49 853

Present value of incremental cash flows 240 239

Less initial advertising expenditure 165 500
 Net present value $74 739

EXERCISE 21.28 (25 minutes) Accounting rate of return: manufacturer

1 Incremental

Incremental operating Incremental Incremental

Year revenue expenses depreciation net profit

1 50 000 20 000 16 667 13 333

2 50 000 20 000 16 667 13 333
3 50 000 20 000 16 667 13 333
4 50 000 20 000 16 667 13 333
5 50 000 20 000 16 667 13 333
6 50 000 20 000 16 667 13 333

Average incremental net profit

2 Accounting rate of return = initial investment
= 13 333/100 000
= 13.33% (rounded)

EXERCISE 21.29 (25 minutes) Performance evaluation; behavioural issues:

government department
The net present value of the new water filtration system is calculated as follows:
Acquisition cost (time 0) $(90 750)
Present value of operating cost savings:
Year 1: $16 500*  0.926† 15 279
Year 2: $17 250  0.857 14 783
Year 3: $19 500  0.794 15 483
Year 4: $27 000  0.735 19 845
Year 5: $30 000  0.681 20 430
Net present value $(4 930)
* Amounts in this column are the annual cash savings from reduced operating costs. Notice that depreciation
expense is not included, since it is not a cash flow.
† The discount factors in this column are from Table 3 in the Appendix (r = 0.08).
The supervisor has made the correct decision but for the wrong reason. Depreciation is not a cash flow
so is not a relevant consideration when calculating a discounted cash flow analysis. The net present
value of the new filtration system is negative, so it should not be purchased.
A potential behavioural problem inherent in this situation is the conflict between (1) investment criteria
based on discounted cash flow methods and (2) performance evaluation based on accrual accounting
concepts. Specifically, the supervisor is concerned that the decision to buy the new water filtration unit
will reduce yearly profits with a yearly depreciation expense of $18 150, which is less than the yearly
cash flows in years 1 and 2. So in the first two years of the project, yearly profits will reduce and the
performance of the supervisor may look poor. Fortunately the project is not an acceptable investment
for the Authority over its seven year life as the acquisition cost of the system is greater than the present
value of the operating cost savings.

EXERCISE 21.30 (10 minutes) After-tax cash flows; profit or loss on disposal:
manufacturer
1 Carrying amount = acquisition cost – accumulated depreciation
= $300 000 – $233 070 = $66 930
2 Loss on sale = carry amount – proceeds of sale
= $66 930– $55 530 = $11 400
3 Reduced cash outflows from the tax deduction from the loss of sale ($11 400  0.4) $4 560
Proceeds of sale 55 530
Total after-tax cash flow $60 090

EXERCISE 21.31 (15 minutes) After-tax cash flows, depreciation: manufacturer

1 Cash flow:
Depreciation deduction
Tax savings
Year Straight line [Col. (2)  0.30]

1 $40 000 (33.33%  $120 000) $12 000

2 $40 000 (33.33%  $120 000)  12 000

3 $40 000 (33.33%  $120 000) 12 000

2 Cash flow:
Depreciation deduction
Tax savings
Year Diminishing value [Col. (2)  0.30]

1 $48 000 (40%  $120 000) $14 400

2 $28 800 (40%  [$120 000 – 48 8 640

000])

3 $17 280 (40%  [$72 000 – 28 5 184

800])
EXERCISE 21.32 (20 minutes) After-tax cash flows, payback period; even cash flows:
wildlife refuge
initial investment
1 Payback period = annul after-tax cash flow

$186 300
= $ 40 500 = 4.6 years
2 Net present value analysis:

Discount rate

8% 10% 12%

Present value of after-tax

savings:

$40 500  5.206 $210 843

$40 500  4.868 $197 154

$40 500  4.564 $184 842

Initial investment (186 300) (186 300) (186 300)

Net present value $24 543 $10 854 $(1 458)

EXERCISE 21.33 (15 minutes) After-tax cash flows, profitability index: service firm
Discount rate

6% 8% 10%

Present value of after-tax

savings:

$12 000  7.360* $88 320

$12 000  6.710* $80 520

$12 000  6.145* $73 740

$80 520 $73 740

Calculation of profitability index
75 000 75 000

Profitability index† (rounded) 1.18 1.07 0.98

* From Table 4 in the Appendix (n = 10).

present value of cash flows, exclusive of initial investment

† Profitability index = initial investment

 
SOLUTIONS TO PROBLEMS

PROBLEM 21.34 (40 minutes) Net present value; qualitative issues: not-for-profit
organisation

1 Net present value analysis:

Retain old machine:
Annual costs:
Variable 300 000  $0.38 $114 000
Fixed 21 000
Total 135 000
Annuity discount factor (r = 12%; n = 6)  4.111
Present value of annual costs 554 985
Salvage value, end of Year 10 $7 000
Discount factor (r = 12%; n = 6) .507
Present value of salvage value (3 549)
Net present value of costs $551 436
New machine:
Annual costs:
Variable 300 000  $0.29 $87 000
Fixed 11 000
Total 98 000
Annuity discount factor (r = 12%; n = 6)  4.111
Present value of annual costs $402 878
Salvage value of new machine, end of Year 10 $20 000
Discount factor (r = 12%; n = 6)  0.507
Present value of new machine’s salvage value (10 140)
Salvage value of old machine, end of Year 4 (40 000)
Acquisition cost of new machine 120 000
Net present value of costs $472 738
Conclusion: Purchase the new machine because the net present value of relevant costs is lower
than with the old machine.
2 The qualitative factors that are important to the decision include the following:
 The lower operating costs (variable and fixed) of the new machine would enable Special
People Industries to meet future competitive or inflationary pressures to a greater degree
than the old machine.
 If the increased efficiency of the new machine is due to labour or energy cost savings, then
additional increases in these costs in the future will favour the new machine even more.
 Maintenance and servicing of both machines should be reviewed for reliability of the
manufacturer and cost.
 The potential technological advances for new machines over the next several years should
be evaluated.
 The space requirements for the new equipment should be reviewed and compared with the
present equipment to determine if more or less space is required.
 The retraining of personnel to use the new machine should be considered.
PROBLEM 21.35 (30 minutes) Net present value; outsourcing: manufacturer
1 Yes. This is a long-term decision, with cash flows that occur over a five-year period. Given that
the cash flows have a ‘value’ dependent on when they take place (e.g. cash inflows that occur in
earlier years have a higher time value than cash inflows that take place in later years),
discounting should be used to determine whether Sure Fire Company should outsource.

2 Sure Fire Company is better off to manufacture the igniters, as the NPV is $82 779 944
compared to the NPV of the cost of outsourcing, which is $85 138 400.

Outsource:

Annual purchase (400 000 units  $62) $(24 800

000)

Annuity discount factor (Table 4*: r = 0.14, n = 5)  3.433

Net present value $(85 138

400)

Manufacture in-house:

Annual variable manufacturing costs (400 000 units  $60) $(24 000
000)

Annual salary and fringe benefits (95

000)

Total annual cash flow. $(24 095

000)

Annuity discount factor (Table 4: r = 0.14, n = 5)  3.433

Present value of annual cash flows $(82 718

135)

New equipment (time 0) (60 000)

Repairs and maintenance: $4500  (0.675 + 0.592 + 0.519) (8 037)

(Table 3: r = 0.14, n = 3, 4 and 5)

Equipment sale: $12 000  0.519 (Table 3: r = 0.14, n = 5) 6 228

Net present value $(82 779

944)
Note: Depreciation is ignored because it is not a cash flow.
* Discount factors from the tables in the Appendix

3 The company would be financially indifferent if the net present value (NPV) of the manufacture
alternative equals the NPV of the outsource alternative. Thus:
Let X = purchase price
3.433  400 000X = $82 779 944
1 373 200X = $82 779 944
X = $60.28 (rounded)
PROBLEM 21.36 (45 minutes) Net present value: government department
1 Current fire control stations
Staff salary ($200 000 x 8 stations) $(1 600 000)
Other operating costs ($100 000 x 8 stations) (800 000)
Total annual cash flow (2 400 000)
Annuity discount factor (Table 4: r = 0.10; n = 10)  6.145
Net present value of costs $(14 748 000)

Proposed perimeter fire control stations

Staff salary ($300 000 x 4 stations) $(1 200 000)
Other operating costs ($110 000 x 4 stations) (440 000)
Total annual cash flow (1 640 000)
Annuity discount factor (Table 4: r = 0.10, n = 10)  6.145
Present value of annual cash flows (10 077 800)
Construction costs, time 0 ($100 000 x 4 stations) (400 000)
Acquisition of equipment, time 0 ($250 000 x 4 stations) (1 000 000)
Salvage value of half of the old equipment, time 0 ($60 000 x 4 stations) 240 000
Demolition of old stations ($10 000 x 8 stations) (80 000)
Net present value of costs $(11 317 800)

Difference in NPV of costs (favours perimeter fire control stations) $ (3 430 200)

2 Qualitative factors to be considered include such issues as public safety and aesthetics. It might
be, for example, that public safety is greater with eight fire control stations dispersed throughout
the wilderness area. Aesthetic considerations, on the other hand, might favour the perimeter
stations that would not mar the beauty of the wilderness area.
PROBLEM 21.37 (25 minutes) Internal rate of return; even cash flows: airport
1 Initial cost of investment in a longer runway:

Land acquisition $ (70 000)

Runway construction (200 000)

Extension of perimeter fence (29 840)

Runway lights (39 600)

New rolling machine (100 000)

Salvage value of old rolling machine    10 000

Initial cost of investment $(429 440)

2 Annual net incremental benefit from runway:

Runway maintenance $ (28 000)

Incremental revenue from landing fees 104 000

Incremental operating costs for new rolling machine (12 000)

Annual incremental benefit $ 64 000

3 Internal rate of return:

Annuity discount factor associated initial cost of investment

=
 with the internal rate of return annual incremental benefit
$ 429 440
= = 6.710
$ 64 000
Find 6.710 in the Year-10 row of Table 4 of the Appendix. It falls in the 8 per cent column, so the
internal rate of return on the runway project is 8 per cent.
Conclusion: From a purely financial perspective, the longer runway should not be approved,
since its internal rate of return (8 per cent) is lower than the hurdle rate (12 per cent). Qualitative
considerations, such as convenience for the city’s residents, should also be considered.
PROBLEM 21.38 (45 minutes) Net present value: airport
1 Net present value analysis:

Runway maintenance $(28 000)

Incremental revenue from landing fees 104 000

Incremental operating costs for new roller (12 000)

Annual incremental benefit $64 000

Annuity discount factor (Table 4: r = .12, n = 10)  5.650

Present value of annual benefits 361 600

Less: Initial costs:

Land acquisition (70 000)

Runway construction (200 000)

Extension of perimeter fence (29 840)

Runway lights (39 600)

New rolling machine (100 000)

Salvage value of old roller   10 000

Net present value $(67 840)

2 From a purely financial perspective, the board should not approve the runway since its net
present value is negative. Qualitative considerations, such as the convenience of local residents,
should also be taken into consideration by the board.

3 (a) Data that are likely to be uncertain include the following:

 annual cost of maintaining new runway
 annual incremental revenue from landing fees.
Each of these data covers a lengthy time horizon. Moreover, they depend on unpredictable
factors, such as the level of economic activity, the inflation rate, and the rate of deterioration of
the runway (which depends on the weather).
(b) The least uncertain data would likely include the following:
 cost of acquiring land
 cost of runway lights
 cost of new roller
 salvage value of old roller.
Almost as certain would be the following:
 cost of runway construction
 cost of extending the perimeter fence.
These data all relate to the present or near future. Acquisition costs can be determined by direct
inquiry, and construction costs can be determined by obtaining estimates or bids from
contractors.
PROBLEM 21.39 (50 minutes) Internal rate of return; uneven cash flows: library
1 Calculation of net savings:
(1) (2) (3) (4) (5) (6)
Projected cost Cost of
Savings on Current cost of of replacing Savings on installing Net savings
monitoring replacing stolen books book sensor with new
Year activity stolen books with new system replacement* panels system†

1 $96 000 $108 000 $90 000 $18 000 $24 000 $90 000

2 96 000 108 000 54 000 54 000 24 000 126 000

3 96 000 108 000 18 000 90 000 24 000 162 000

4 96 000 108 000 $0 108 000 $0 204 000

5 96 000 108 000 $0 108 000 $0 204 000

6 96 000 108 000 $0 108 000 $0 204 000

7 96 000 108 000 $0 108 000 $0 204 000

8 96 000 108 000 $0 108 000 $0 204 000

9 96 000 108 000 $0 108 000 $0 204 000

10 $96 000 108 000 $0 108 000 $0 204 000

* Column (2) amount – column (3) amount.
† Column (1) amount + column (4) amount – column (5) amount.
2 Internal rate of return: Using trial and error, let’s try 14, 16 and 18 per cent.

Net savings with 14% 16% 18%

new security discount Present value discount Present value discount Present value
system factor using 14% factor using 16% factor using 18%

$90 000 0.877 $78 930 0.862 $77 580 0.847 $76 230

126 000 0.769 96 894 0.743 93 618 0.718 90 468

162 000 0.675 109 350 0.641 103 842 0.609 98 658

204 000 0.592 120 768 0.552 112 608 0.516 105 264

204 000 0.519 105 876 0.476 97 104 0.437 89 148

204 000 0.456 93 024 0.410 83 640 0.370 75 480

204 000 0.400 81 600 0.354 72 216 0.314 64 056

204 000 0.351 71 604 0.305 62 220 0.266 54 264

204 000 0.308 62 832 0.263 53 652 0.225 45 900

204 000 0.270 55 080 0.227 46 308 0.191 38 964

$875 958 $802 788 $738 432

Cost of modifying exits (time 0) (360 000) (360 000) (360 000)

Cost of equipment (time 0) (442 788) (442 788) (442 788)

$73 170 $0 ($64 356)

 The internal rate of return on the new security system is 16 per cent, since the net present value
is zero when the cash flows are discounted at 16 per cent.
3 The board should approve the new security system, because its internal rate of return (16 per
cent) exceeds the hurdle rate (12 per cent).
4 The most difficult data to estimate would be the cost of replacing stolen books if the new security
system is installed. These estimates extend over ten years, and the library has no experience
with the system. The least difficult data to estimate would be the cost of modifying the library’s
exits and the cost of the new equipment. These amounts can be obtained from contractors’ bids
and price quotations.

PROBLEM 21.40 (30 minutes) Internal rate of return; net present value; uneven cash
flows: library
1 If the cost of installing new sensor plates is spread over the first six years instead of the first
three, the net savings in the first three years will increase and the net savings in years 4, 5 and 6
will decline by an equivalent amount. Thus, the same total net savings will be obtained, but the
savings will be realised earlier. Due to the time value of money, this will cause the new security
system’s internal rate of return to increase.

2 Net present value analysis:

Subtract
new
Schedule of net Add back sensor Revised Discount
savings from sensor costs costs for schedule of factor Present value of
Year problem above (Year 1– 3) Year 1– 6 net savings (r=12%) net savings

1 $90 000 $24 000 ($12 000) $102 000 0.893 $ 91 086

2 126 000 24 000 (12 000) 138 000 0.797 119 986

3 162 000 24 000 (12 000) 174 000 0.712 123 888

4 204 000 0 (12 000) 192 000 0.636 122 112

5 204 000 0 (12 000) 192 000 0.567 108 864

6 204 000 0 (12 000) 192 000 0.507 97 344

7 204 000 0 0 204 000 0.452 92 208

8 204 000 0 0 204 000 0.404 82 416

9 204 000 0 0 204 000 0.361 73 644

10 $ 204 000 0 0 204 000 0.322 65 688

Present value of savings $977 236

Cost of modifying exits (time 0) ($360 000)

Cost of equipment (time 0) ($442 788)

Net present value $174 448

The net present value is positive, so the new security system should be installed.
PROBLEM 21.41 (25 minutes) Payback; accounting rate of return; NPV: manufacturer

1 The project’s payback period is 4.43 years calculated as follows:

After-tax cash
Year flows

1 $50 000

2   45 000

3   40 000
4 (after 5.14 months) 15 000 (.43  $35 000)

Total 150 000

Initial cost $150 000

2 The accounting rate of return is 12.67 per cent, calculated as follows:

Accounting rate of return = average net profit

initial investment
= $19 000
$150 000 = 12.67 per cent (rounded)

3 Net present value calculations

After-tax Discount Present

Year cash flow factor* value

0 $(150 000) 1.000 $(150 000)

1   50 000 0.909   45 450

2   45 000 0.826   37 170

3   40 000 0.751   30 040

4   35 000 0.683   23 905

5   30 000 0.621   18 630

Net present value $5 195

* From Table 3 in Appendix (r = 0.10).

PROBLEM 21.42 (30 minutes) Net present value; payback period; accounting rate of
return: pancake house

1 (a) Suburban shopping centre restaurant:

Net after-tax cash inflows $50 000

 Annuity discount factor (r = 0.10, n = 20)  8.514

Present value of annual cash flows 425 700

Cash outflow at time 0  400 000

Net present value $25 700

(b) City restaurant:

Net after-tax cash inflows $35 800

 Annuity discount factor (r = 0.10, n = 10)  6.145

Present value of annual cash flows 219 991

Cash outflow at time 0  200 000

Net present value $19 991

initialinvestment
2 (a) Payback period = annual after-tax cash inflow
(i) Suburban restaurant:
$ 400 000
Payback period = $ 50 000 = 8 years
(ii) City restaurant:
$200 000
Payback period = $ 35 800 = 5.6 years (rounded)

æ average ö æaverage incremental expensesö

çincremental÷ - ç (including depreciation and ÷
ç ÷ ç ÷
è revenue ø è income taxes) ø
(b) Accounting rate of return = initial investment

(i) Suburban restaurant:

$ 50 000
 
Accounting rate of return = $ 400 000 = 12.5%
(ii) City restaurant:
$ 35 800
Accounting rate of return = $200 000 = 17.9%

(c) The owner’s criteria will lead to a rejection of both sites since the payback period of each is
greater than 5 years. Only the city restaurant has an accounting rate of return in excess of
15 per cent; its accounting rate of return is 17.9 per cent. Note that when the time value of
 money is considered, the NPV of the suburban shopping centre site is more favourable.

(d) Neither the payback period nor the accounting rate of return method considers the time
value of money. Moreover, the payback method ignores cash flows beyond the payback
period.
On the positive side, both methods can provide a simple means of screening a large
number of investment proposals. However, in this case the owner would reject two
profitable projects where profitability is determined by discounting at his hurdle rate of 10
per cent.
The owner should consider the basis for discounting at 10 per cent. If it represents his cost
of capital he should rethink making the decision on the basis of ARR and payback period.
If it is less than his cost of capital he should consider changing his discount rate to
something more appropriate.
 PROBLEM 21.43 (50 minutes) After-tax cash flows; NPV; investment allowance; new
equipment: manufacturer

1 Calculation of incremental after-tax cash flows:

Initial outflow:
Purchase of new equipment $(450 000)
One time transfer expense (net of tax) (45 000 x 0.64) (28 800)
Proceeds of sale of old equipment 7 500
Increase in tax due to profit on sale of old equipment (7500 x 0.36) (2 700)
Total initial cash outflow $(474 000)
Annual operation:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Cash operating savings $135 000 $225 $225 $225 $225 $225 $225 $225
000 000 000 000 000 000 000

Less tax expense (48 600) (81 (81 (81 000) (81 000) (81 000) (81 (81 000)
000) 000) 000)

Cash savings after tax 86 400 144 000 144 000 144 000 144 000 144 000 144 000 144 000

Depreciation effect* 24 300 24 300 24 300 24 300 24 300 24 300 16 200

Investment allowance

(45 000  0.36) 16 200

After-tax operating ______ ______ ______ ______ ______ ______ ______ ______
_

cash flows $126 900 $168 $168 $168 $168 $168 $160 $144
300 300 300 300 300 200 000

* Depreciation schedule:

Year Rate  Principal = Depreciatio  Tax rate = Tax effect

n

1 0.15  $450 000 = $ 67 500  0.36 = $24 300

2 0.15  450 000 = 67 500  0.36 = 24 300

3 0.15  450 000 = 67 500  0.36 = 24 300

4 0.15  450 000 = 67 500  0.36 = 24 300

5 0.15  450 000 = 67 500  0.36 = 24 300

6 0.15  450 000 = 67 500  0.36 = 24 300

7 0.10  450 000 = 45 000  0.36 = 16 200

8 – – $450 000
2 Net present value analysis:

(a) (b) (c) (d) (e) (f)

Present $
$
Income Discoun value of
$
tax After tax t factor cash
Year Amount impact cash flow (10%) flows

1 Equipment purchase 0 ($450 ($450 000) 1.000 ($450

000) 000)

2 Transfer of activities 0 (45 000) (1 – 0.36) (28 800) 1.000 (28 800)

3 Proceeds from sale of 0 7 500 7 500 1.000 7 500

old equipment

4 Profit on sale of old

pump:
Proceeds $7500
Carrying amount $0
0 (7 500) 0.36 (2 700) 1.000 (2 700)
Profit on sale $7500

5 Investment allowance
$450 000  0.10 = $45 1 45 000 0.36 16 200 0.909 14 726
000

6 Depreciation: 15% 1 67 500 0.36 24 300 0.909 22 089

straight line, which
2 67 500 0.36 24 300 0.826 20 072
means 6 years @ 15%
p.a. ($450 000  0.15) = 3 67 500 0.36 24 300 0.751 18 249
$67 500 p.a. plus year 7
4 67 500 0.36 24 300 0.683 16 597
@ 10% = $45 000
5 67 500 0.36 24 300 0.621 15 090
6 67 500 0.36 24 300 0.564 13 705
7 45 000 0.36 16 200 0.513 8 311

7 Annual operating cost 1 135 000 (1 – 0.36) 86 400 0.909 78 538

savings
2–8 $225 000 (1 – 0.36) $144 000 4.426 637 344

Net present value $370 721

Recommendation: Management should purchase the new equipment because the NPV is
positive.
PROBLEM 21.44 (45 minutes) After-tax cash flows; various methods of investment
analysis: manufacturer
1

Before- After-tax After-tax

tax

Cash flows Timing amount Tax effect cash flow net profit

Investment Year 0 $(216 000) – $(216 000) –

Cash savings Years 1 – $ 84 000 $(33 600) $ 50 400 $50 400

5

Depreciation effect Years 1 – (43 200) 17 280 17 280 (25 920)

5
Totals $ 67 680 $ 24 480

investment $216 000

(a) Payback period = after-tax cash flow = $67 680 = 3.19 years
annual after-tax net profit
(b) Accounting rate of return = investment ( initial or average)
Initial investment Average investment
$24 480 $24 480
$216 000 = 11.3% $108 000 = 22.7%
(c) Net present value = (after-tax cash flows × annuity discount factor)
– initial investment
= ($67 680  3.605) – $216 000
= $ 27 986 (rounded)
present value of after-tax cash flows
(d) Profitability index (PI) = initial investment
$67680× 3 .605
= $216 000 = 1.13 (rounded)
(e) The internal rate of return is approximately 17 per cent.*
* 216 000/67 680 = 3.191 so look for this figure along the Year-5 row in the annuity discount, Table 4.
It lies between 3.274 and 3.127. This discount factor would give a NPV of zero so must be the IRR.

2 The payback method is inferior because it ignores the time value of money and cash proceeds
beyond the payback period. However, it is useful in that it tells management how long it will take
to recoup its original investment.
The accounting rate of return method is inferior because it uses accounting profit and investment
instead of cash flows. In addition, it also ignores the time value of money.
The net present (NPV), profitability index (PI), and internal rate of return (IRR) methods are
similar. These three discounted cash flow methods consider the time value of money and the
timing of cash flows. Consequently, they are all superior to the first two methods.
PROBLEM 21.45 (40 minutes) After-tax cash flows; investment in advanced
technologies: manufacturer
1&2

(a) (b) (c) (d) (e) (f)

Discou
Income nt Present
tax After-tax factor value of
Year Amount impact cash flow (14%) cash flows

Equipment purchase 0 $(120 000) $(120 000) 1.000 $(120 000)

Implementation costs 0 (80 000) (80 000) 1.000 (80 000)

Working capital reduction* 0 8 000 8 000 1.000 8 000

Annual cash flows:

Rework savings 28
000
Rent reduction 8
1–10 36 000 (1 – 0.40) 21 600 5.216 112 666
000
Increased revenue 16
000
CIM maintenance (16
000)
Savings per annum $36
000

Depreciation over 10
years:
Cost $120 000
Implementation 80 000
Salvage value (10 000)
Total $190 000
1–10 19 000 0.40 7 600 5.216 39 642
Depreciation is $19 000
p.a.

Proceeds of sale 10 10 000 10 000 0.2700 2 700

Net present value $(36 992)

* While it is not specified in the question, some students might also want to recognise the increase in working
capital at the end of the life of the CIM.
The analysis indicates that the new investment yields a negative NPV, which suggests that
Italiano Footwear should not go ahead with the new investment. However, the company will need
to consider if there are any competitive or marketing issues that may also need to be taken into
account. These factors may be difficult to capture in financial terms and may be used to qualify
the financial analysis.
3 Calculating the after-tax payback period:

After-tax Cumulative

Year cash flow total

0 $(192 000) $(192 000)

1 29 200 (162 800)
2 29 200 (133 600)
3 29 200 (104 400)
4 29 200 (75 200)
5 29 200 (46 000)
6 29 200 (16 800)
7 29 200 12 400
8 $30 800 $41 600

The payback period is 6.58 years*

* 16 800/29 200 = 0.58 years

4 It is difficult to quantify many aspects of a strategic investment. In particular, it is difficult to

assess the impact of not going ahead with the investment, or the impact of competitors’ future
actions.
SOLUTIONS TO CASES
CASE 21.46 (60 minutes) Decision problem with alternatives; NPV; IRR; ethics: school
1 The two main alternatives for the board of management are:
(a) Use full-size buses on regular routes.
(b) Use minibuses on regular routes.

2 If the board decides to use minibuses, then there are two options for the full-size buses:
(a) Sell the full-size buses.
(b) Keep the full-size buses in reserve.

3 Net present value analysis of options for full-size buses:

(a) Sell five full-size buses:
Sales proceeds ($30 000  5) = 150 000*
* No discounting necessary, since the buses would be sold now (time 0).
(b) Annual savings on bus charter fees:
($60 000 – 10 000) $50 000
 Annuity discount factor
(Table 4: r = 0.12, n = 5)  3.605
Present value of savings $180 250
The full-size buses should be kept in reserve, since the NPV of that option is greater.

4 Net present value analysis of minibus purchase decision:

In the following incremental cost analysis, parentheses denote cash flows favouring the full-size
bus alternative.
Incremental annual cost of salaries for bus drivers if minibuses are used
($18 000  3 more buses required) $ (54 000)
Incremental annual maintenance and operating costs if minibuses are used
[($20 000  8) – ($50 000  5)] 90 000
Incremental annual cash flow (favours minibuses) 36 000
 Annuity discount factor (Table 4: r = 0.12, n = 5)  3.605
Present value of incremental annual cash flows $129 780
Cost of redesigning bus routes, retraining drivers etc. (time 0) (15 250)
Acquisition cost of minibuses ($54 000  8) (432 000)
Present value of savings on bus charter fees, if minibuses are purchased (from requirement 3)
180 250
Net present value $(137 220)
The minibuses should not be purchased.
5 Internal rate of return on the minibuses:
(a) First, calculate the annual cost savings if the minibuses are used.
(Remember that the full-size buses will be kept in reserve.)
Annual savings on bus charter fees ($60 000 – 10 000) $50 000
Annual incremental maintenance and operating costs
($20 000  8) – ($50 000  5)] 90 000
Annual incremental cost of compensation for bus drivers
($18 000  3 more buses required) (54 000)
Total annual cost savings if minibuses are used $86 000
(b) Second, calculate the initial cost if the minibuses are purchased:
Cost of redesigning bus routes, retraining drivers, etc. $(15 250)
Acquisition cost of minibuses ($54 000  8) (432 000)
Initial cost $(447 250)
(c) Third, find the internal rate of return:
Annuity discount factor associated with the internal rate of return

initial cash outflow $ 447250

= annual cost savings = $ 86 000 = 5.201 (rounded)
Find 5.201 in the Year-5 row of Table 4 in the Appendix. It lies below the 4 per cent column, so
the IRR on the minibus alternative is less than 4 per cent.

6 Irrelevant information: The cost of purchasing a full-size bus ($180 000) is irrelevant, because
the board is not contemplating the purchase of any full-size buses. The depreciation method
(straight-line) is also irrelevant, because depreciation is not a cash flow. The NPV and IRR
methods focus on cash flows.

7 Peter Reynolds, the sales manager at the Ford dealership, is acting improperly. First, he
shouldn’t try to pressure his friend into recommending that the minibuses be purchased. Second,
he should not use the lure of a better job to try to persuade his friend to recommend in favour of
the minibuses. Third, when the financial job becomes available at the dealership, there should be
a search for the best qualified individual. It is not clear that Reynolds is in a position to offer the
job to his friend. Ethical standards demand that Michael Jeffries refuse to alter his
recommendation to the school board. The NPV analysis indicates that the full-size bus option is
preferable, and he should recommend accordingly.
CASE 21.47 (50 minutes) After-tax cash flows; investment in robotic manufacturing
equipment; net present value; IRR; payback: manufacturer
1 (a) Calculation of NPV:

$
Discou Present
$ Income $ nt value of
tax After-tax factor cash
Year Amount impact cash flow (12%) flows

1 Equipment purchase 0 (945 (945 000) 1.000 (945 000)

000)
Discount received 0 (1 – 0.40) 11 340 1.000 11 340
18 900
Freight 0 (11 000) 1.000 (11 000)
(11 000)
Installation costs 0 (22 900) 1.000 (22 900)
(22 900)

2 Sale of old equipment:

Proceeds $1 500
Book value $ 0
Profit on sale $1 500 0 1 500 (1 – 0.40) 900 1.000 900

3 Working capital reduction 0 2 500 2 500 1.000 2 500

4 Manufacturing cost savings:

Unit purchase price $27.00
Manufacturing cost:
Material $8.00 1 350 000 (1 – 0.40) 210 000 0.893 187 530
Direct labour 7.50 2 350 000 (1 – 0.40) 210 000 0.797 167 370
Variable OH 4.50 3 364 000 (1 – 0.40) 218 400 0.712 155 501
20.00 4 385 000 (1 – 0.40) 231 000 0.636 146 916
Savings per unit 7.00 5 385 000 (1 – 0.40) 231 000 0.567 130 977
 annual production

5 Depreciation over 3 years:

Cost $945 000
Freight 11 000
Installation 22 900
Total $978 900
@ 33 1/3% p.a. = $326 300 1–3 326 300 0.40 130 520 2.402 313 509

6 Supervision required if
manufactured
1–5 (90 000) (1 – 0.40) (54 000) 3.605 (194 670)

7 Salvage value of
equipment:
Proceeds $12
000
Book value $ 0
Profit on sale $12 000 5 12 000 (1 – 0.40) 7 200 0.567 4 086

Net present value (52 941)

(b) Calculation of IRR:

Working Manu- Sale

Total Sale of capital facturin Depreci Super- of
Yea investme old reductio g cost ation tax vision equip Net cash
r nt equipt n saving relief cost ment flow

0 -967 560 900 2500 -964 160

1 210000 130520 -54000 286 520

2 210000 130520 -54000 286 520

3 218400 130520 -54000 294 920

4 231000 -54000 177 000

5 231000 -54000 7200 184 200

Net Disc Disc. Disc. Disc.

cash factor PV @ factor PV @ factor PV @ factor PV @
Year flow 9% 9% 9.55% 9.55% 10% 10% 12% 12%

-
0 964160 1 -964160 1 -964160 1 -964160 1 -964160

28652 262862.3 0.9128 0.9090 260472.7 0.8928 255821.4

1 0 0.91743 8 2 261542. 9 2 5 2

28652 241158.1 0.8332 0.8264 236793.3 0.7971 228411.9

2 0 0.84167 5 4 238742. 4 8 9 8

29492 227732.3 0.7606 0.7513 221577.7 0.7117 209918.2

3 0 0.7348 5 1 224319. 1 6 8 3

17700 125391.2 0.6943 0.6830 120893.3 0.6355 112486.6

4 0 0.70842 6 0 122892. 1 8 1 9

18420 119717.3 0.6337 0.6209 114373.7 0.5674 104520.0

5 0 0.64993 6 7 116742. 2 0 2 2

- -
NPV 12701.51 79.1373 10049.03 53001.62*

*
Different to part (a) because the spreadsheet used a formula and was more accurate than the table to three places of
decimals.

IRR is about 9.55%.

 (c) Calculation of payback period:

After-
tax
Yea cash Cumulativ
r flow e

-964
0 160 -964 160

1 286 520 -677 640

2 286 520 -391 120

3 294 920 -96 200

4 177 000 80 800

5 184 200 265 000

96 200
= 0.5435
177 000

Payback = 3.54 years

2 Based on the discounted cash flow analysis, Paper Solutions should not purchase the new
equipment since the project shows a negative net present value of $(52 941) and the internal
rate of return is about 9.55 per cent, well below the discount rate of 12 per cent (it is assumed
that the hurdle rate for the IRR ≥ 12 per cent).
3 Payback is simple to use and provides a suitable screening approach to reject clearly unsuitable
projects before much effort goes into more detailed analysis. It is also useful for companies that
have cash flow problems, as they may need to take the payback into consideration. Finally it
can give an indication of risk. If a project shows a good NPV and IRR but is very slow to pay
back, it can be recognised that the DCF methods are relying quite heavily on the less certain
long-term cash flows. There is more uncertainty in the cash flows that are further into the
project.
4 Other issues to consider in making the choice between buying equipment and purchasing the
containers include:
 What will be the reaction of staff to losing a supervisor?
 Can the quality of the containers be assured?
 Might the supplier of containers increase the price once the ability to make them has been
lost?
 Can timely delivery of the containers be guaranteed?