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CHAPTER 22

DISCUSSION QUESTIONS

22-1

Q22-1. Effective planning and control of capitalexpenditures are important because:

(a) financial risk is increased by long-termcommitments;

(b) the magnitude of capital expenditures issubstantial and the penalties for unwise

decisions are usually severe;(c) decisions made in this area provide the

supporting structure for operating activi-

ties of the firm.Q22-2. Examples of opportunities and temptations

for unethical behavior in the capital budgetingarea include:

(a) pressure applied to the cost/managerialaccountant by superiors or associates to

circumvent the capital expenditureapproval process, in order to get a petproject approved;

(b) pressure to write off or devalue assetsbelow their true value in order to justify

replacement;(c) exaggerating the expected economic bene-

fits of a pet project in order to increase thelikelihood of getting it approved

Q22-3. The cost/managerial accountant has an obli-gation to the company to make sure that thecompanys legitimate policies and procedures

are not circumvented and to make sure thatthe data used in the evaluation of capital

expenditure proposals are as reliable andrealistic as possible. If an ethical violationoccurs, the cost/managerial accountant

should first discuss the perceived problemwith his or her immediate supervisor (in order

to clarify the significance of the problem andidentify possible courses of action) and then

with the individual or individuals involved. If

the individual involved is the accountantsimmediate supervisor, the cost/managerial

accountant should consult the next higherlevel of management. If the problem cannot

be resolved through discussion, thecost/managerial accountant is obligated to

provide a full disclosure of all the details to theexecutives responsible for evaluating andapproving capital expenditures.

Q22-4. The economic life of a project is the periodduring which it produces earnings. It need

not, and probably will not, be equal to thephysical life of the related asset(s). Its length

depends primarily upon the obsolescence othe product or manufacturing process

involved or the nature of the product itselfManagers usually find it quite difficult to estimate economic life because it depends upon

future events over which they may have littleor no control.

Q22-5. Cash outflows that might be expected for acapital expenditure include:

(a) purchase price of one or more assets (oa down payment if property is purchased

on installment);(b) construction period interest and taxes i

the property is being constructed;

(c) machinery and equipment setup costparticularly if machinery being evaluated

utilizes a more advanced technology thanthat currently in use;

(d) computer software development cost if acomputer aided design, computer aided

manufacturing, or fully computer integrated manufacturing system is beingpurchased;

(e) increased annual maintenance and/opower costs resulting from more compli

cated or technologically advanced machinery or equipment;

(f) lease payments, if some or all of the

assets being acquired in the project areleased;

(g) working capital requirements (inventorycash on hand, receivables, payables

etc.) may increase as a result o

increased business generated by thecapital project.

Q22-6. Cash inflows that might be expected from acapital expenditure include:

(a) revenues from additional business generated by the project;

(b) cost savings created by the capital expenditure that result in a reduction of cashoutflows (e.g., maintenance savings

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labor savings, reduced inventory require-

ments resulting from reduced setuptimes, etc.);

(c) retention of market share that might havebeen lost if the capital expenditure were

not made (particularly in the case ofadvanced technologies that improveproduct quality, reduce costs, provide

manufacturing flexibility, etc. that can pro-vide a competitive advantage to the firm

with the technology);(d) salvage from the sale of the property at

the end of the economic life of the capital

project.Q22-7. Some nonquantifiable benefits from investing

in advanced manufacturing technologies,such as CIM, FMS, and robotics, include:

(a) improved product quality (ability to meetcloser production tolerances and at the

same time reduce the variability in pro-duction output);

(b) decreased machine setup and shorter

manufacturing cycle times (which providethe company with the ability to adjust out-

put quantity and variety quickly to meetrapidly changing customer demands).

Q22-8. Tax depreciation is quite likely to differ frombook depreciation because the cost recoveryperiod used for tax purposes is usually

shorter than the economic life of the asset

used for financial accounting purposes. Also,an accelerated method of depreciation is typ-ically used for tax purposes, whereas the

straight-line method is more often used forbook purposes.

Q22-9. Book depreciation should not be considered

in estimating the future cash flows from a proj-ect because book depreciation has no effect

on the amount or timing of cash flows.Q22-10. Tax depreciation should be considered in esti-

mating the future cash flows from a projectbecause tax depreciation reduces taxableincome and, therefore, tax liability.Tax depreci-

ation results in a tax savings, i.e., a reduction

of tax liability that is a cash outflow. The timing

of cash flows is affected by the tax depreciationmethod and the recovery period used.

Q22-11. Financial accounting data are not entirelysuitable for use in evaluating capital expendi-

ture proposals because:(a) Financial accounting uses the accrual

basis. Capital expenditure decisions gen-

erally rely on estimates of cash flows,rather than revenues and expenses

determined on the accrual basis.(b) Financial accounting is designed to

measure periodic earnings. Capital

expenditure evaluation is concerned withthe life of a given project, which seldom

corresponds to usual accounting periods.(c) Financial accounting measures the

results of operations of a company or asegment of a company. Although this

entity sometimes corresponds with a cap-ital expenditure project, it is usually com-posed of many intermingled capital

expenditure projects.(d) Financial accounting capitalizes expendi-

tures if the expenditure is deemed to havea future value or benefit to the company.

Capitalization is an attempt to matchexpenditures with revenues generated bythose expenditures. When future value or

benefit cannot be reliably measured,

financial accounting treats the expendi-ture as a period expense rather than asan asset acquisition.

Q22-12. Benefits of following up project results include:(a) comparison of actual with projected

results to ensure that a project is meeting

expected performance, or taking correc-tive action or terminating a project that is

not achieving expected performance;(b) evaluation of accuracy of projections from

different departments;(c) improvement of future capital estimates;(d) motivation of personnel arising from

knowledge that follow-up will occur.

22-2 Chapter 22

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EXERCISES

E22-1

Estimated Unit Unit Unit Net PretaxDemand Sales Variable Contribution Cash Inflows

Year in Units Price Cost Margin From Sales1 12,000 $25 $15 $10 $120,0002 12,000 25 15 10 120,0003 12,000 25 15 10 120,0004 12,000 25 15 10 120,0005 12,000 25 15 10 120,000

Total net pretax cash inflows from sales....................................... $600,000Initial cash outflow (cost of asset) .............................. $500,000Less pretax estimated salvage value ........................... (100,000) 400,000

Excess of net pretax cash inflows over cost ................................ $200,000

E22-2

Estimated Unit Unit Unit Net PretaxDemand Sales Variable Contribution Cash Inflows

Year in Units Price Cost Margin From Sales1 6,000 $12 $9 $3 $ 18,0002 8,000 12 9 3 24,0003 10,000 12 9 3 30,0004 10,000 12 9 3 30,0005 10,000 12 9 3 30,0006 10,000 12 9 3 30,000

7 10,000 12 9 3 30,0008 8,000 12 9 3 24,0009 6,000 12 9 3 18,000

10 4,000 12 9 3 12,000

Total net pretax cash inflows from sales....................................... $246,000Initial cash outflow (cost of machine) .......................... $150,000Less pretax estimated salvage value ........................... (20,000) 130,000

Excess of net pretax cash inflows over cost ................................ $116,000

Chapter 22 22-3

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E22-3

Estimated 6% Annual Price-levelNet Pretax Price-level Adjusted Net

Year Cash Inflows Adjustment Cash Inflows1 $15,000 (1 + .06)1 = 1.060 $15,9002 20,000 (1 + .06)2 = 1.124 22,4803 20,000 (1 + .06)3 = 1.191 23,8204 20,000 (1 + .06)4 = 1.262 25,2405 15,000 (1 + .06)5 = 1.338 20,0706 10,000 (1 + .06)6 = 1.419 14,190

Total price-level adjusted net pretax cashinflows from operations ........................................... $121,700

Plus cash inflow from salvage ........................... $5,000Price-level adjustment ........................................ 1,419 7,095

Total price-level adjustednet pretax cash inflows ............................................ $128,795

Less initial cash outflow ................................................... 75,000

Excess of net pretax cash inflows overinitial cash outflow.................................................... $53,795

E22-4

Estimated 9% Annual Price-levelNet Pretax Price-level Adjusted Net

Year Cash Inflows Adjustment Cash Inflows

1 $20,000 (1 + .09)1 = 1.090 $ 21,8002 30,000 (1 + .09)2 = 1.188 35,6403 40,000 (1 + .09)3 = 1.295 51,8004 60,000 (1 + .09)4 = 1.412 84,7205 60,000 (1 + .09)5 = 1.539 92,3406 60,000 (1 + .09)6 = 1.677 100,6207 60,000 (1 + .09)7 = 1.828 109,6808 60,000 (1 + .09)8 = 1.993 119,5809 40,000 (1 + .09)9 = 2.172 86,88010 20,000 (1 + .09)10 = 2.367 47,340

Total price-level adjusted net pretax cashinflows from operations............................................... $750,400

Plus cash inflow from salvage........................... $10,000Price-level adjustment ........................................ 2.357 23,670

Total price-level adjustednet pretax cash inflows ............................................... $774,070

Less initial cash outflow....................................................... 250,000

Excess of net pretax cash inflows overinitial cash outflow ...................................................... $524,070

22-4 Chapter 22

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Chapter 22 22-5

E22-5

(1

)

(2)

(3)

(4)

(5)

(6)

Ann

ual

Additional

TaxLiability

Ne

t

Operating

Maintenance

Tax

Taxable

With40%

After-tax

Savings

Cost

Depre-

Income

TaxRate

CashIn

flows

Year

With

CIM*

WithCIM

ciation**

(1)(2)(

3)

40%

(4)

(1)(2)(5)

1

$400,000

$200,000

$120,000

$80,000

$32,000

$168,0

00

2

400,000

200,000

192,000

8,000

3,200

196,8

00

3

400,000

200,000

115,200

84,800

33,920

166,0

80

4

400,000

200,000

69,000

131,000

52,400

147,6

00

5

400,000

200,000

69,000

131,000

52,400

147,6

00

6

400,000

200,000

34,800

165,200

66,080

133,9

20

Totalnetafter-taxcashinflows..................................................................................................

$960,0

00

Lessinitialcashoutf

lowtopurchasesystem..........................................................................

600,0

00

Excessofnetafter-ta

xcashinflowsoverinitialcashoutflow...............................................

$360,0

00

*Annualhoursofoperatingcapacity

20,000

Savingsperhou

rwithCIM

$20

$400,000

**

MACRS5-year

Depreciable

Tax

Year

RecoveryRate

Basis

Depreciation

1

.200

$600,000

$120,000

2

.320

600,000

192,000

3

.192

600,000

115,200

4

.115

600,000

69,000

5

.115

600,000

69,000

6

.058

600,000

34,800

1.000

$600,000

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E22-6

(1) (2) (3) (4) (5)Estimated Taxable Tax Liability Net

Inflation- Tax Income With 40% After-taxAdjusted Net Depre- (Loss) Tax Rate Cash InflowsYear Cash Inflows ciation* (1) (2) 40% (3) (1) (4)

1 $30,000 $40,000 $(10,000) $(4,000) $ 34,0002 40,000 64,000 (24,000) (9,600) 49,6003 50,000 38,400 11,600 4,640 45,3604 60,000 23,000 37,000 14,800 45,2005 70,000 23,000 47,000 18,800 51,2006 80,000 11,600 68,400 27,360 52,6407 60,000 0 60,000 24,000 36,000

Total net after-tax cash inflows........................................................ $314,000

Less initial cash outflow to purchase system ............................... 200,000Excess of net after-tax cash inflows over initial cash outflow..... $114,000

* MACRS 5-year Depreciable TaxYear Recovery Rate Basis Depreciation

1 .200 $200,000 $ 40,0002 .320 200,000 64,0003 .192 200,000 38,4004 .115 200,000 23,0005 .115 200,000 23,000

6 .058 200,000 11,6001.000 $200,000

22-6 Chapter 22

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E22-7

(1) (2) (3) (4) (5)Estimated Taxable Tax Liability Net

Periodic Tax Income With 40% After-taxNet Cash Depre- (Loss) Tax Rate Cash InflowsYear Inflows ciation* (1) (2) 40% (3) (1) (4)

1 $10,000 $14,300 $(4,300) $(1,720) $ 11,7202 15,000 24,500 (9,500) (3,800) 18,8003 20,000 17,500 2,500 1,000 19,0004 25,000 12,500 12,500 5,000 20,0005 25,000 8,900 16,100 6,440 18,5606 25,000 8,900 16,100 6,440 18,5607 25,000 8,900 16,100 6,440 18,5608 20,000 4,500 15,500 6,200 13,800

9 15,000 0 15,000 6,000 9,00010 10,000 0 10,000 4,000 6,000

Total net after-tax cash inflows ................................................................ $154,000After-tax cash inflow from salvage at end of economic life:

Pretax cash inflow from salvage................................. $10,000Less tax payable on sale at 40% tax rate................... 4,000 6,000

Total net after-tax cash inflows ................................................................ $160,000Less initial cash outflow to purchase system ......................................... 100,000

Excess of net after-tax cash inflows over initial cash outflow .............. $ 60,000

* MACRS 7-year Depreciable TaxYear Recovery Rate Basis Depreciation

1 .143 $100,000 $ 14,3002 .245 100,000 24,5003 .175 100,000 17,5004 .125 100,000 12,5005 .089 100,000 8,9006 .089 100,000 8,9007 .089 100,000 8,9008 .045 100,000 4,500

1.000 $100,000

Chapter 22 22-7

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Problems

P22-1(1) (2) (3)

Inflation-AdjustedEstimated

Periodic CashCash Inflows

Year Inflows 8% Price-Level Adjustment (1) (2)

1 $19,000 (1 + .08) = 1.080 $ 20,5202 22,000 (1 + .08)2 = 1.166 25,6523 24,000 (1 + .08)3 = 1.260 30,2404 18,000 (1 + .08)4 = 1.360 24,4805 15,000 (1 + .08)5 = 1.469 22,035

6 10,000 (1 + .08)6 = 1.587 15,870$109,000 $138,797

(1) (2) (3)Depre- 5-Year Taxciable Property Depre-

Basis of Recovery ciationYear Property Percentage (1) (2)

1 $60,000 .200 $12,0002 60,000 .320 19,200

3 60,000 .192 11,5204 60,000 .115 6,9005 60,000 .115 6,9006 60,000 .058 3,480

$60,000

22-8 Chapter 22

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Chapter 22 22-9

P22-1(Concluded) (1

)

(2)

(3)

(4)

(5)

(6)

Federal

Ne

t

Adju

sted

Taxable

and

After-tax

Estim

ateof

Tax

Income

State

Income

Cas

h

NetCash

Depre-

(Loss)

Income

Tax

Inflo

ws

Year

Inflows

ciation

(1)(2)

TaxRate

(3)(4)

(1)

(5)

1

$20,

520

$12,000

$8,520

40%

$3,408

$17,1

12

2

25,

652

19,200

6,452

40%

2,581

23,0

71

3

30,

240

11,520

18,720

40%

7,488

22,7

52

4

24,

480

6,900

17,580

40%

7,032

17,4

48

5

22,

035

6,900

15,135

40%

6,064

15,9

81

6

15,

870

3,480

12,390

40%

4,956

10,9

14

Totalestimatedneta

fter-taxcashinflowsfrom

project..........................................................

$107,2

78

Lessinitialcashoutl

ayformachinery......................................................................................

60,0

00

Excessofafter-taxcashinflowsfrom

projectov

erInitialcashoutflow...............................

$47,2

78

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P22-2

Cost of new machine ....................................................................................... $18,000Trade-in allowance for old machine................................................................ 9,000

Net cash outflow at beginning of project....................................................... $ 9,000Tax basis of old machine traded in ................................................................ 8,000

Tax basis of new machine ............................................................................... $17,000

Annual cost of operating old machine........................................................... $20,000Annual cost of operating new machine ......................................................... 16,400

Annual cost savings with new machine......................................................... $ 3,600

(1) (2) (3)Tax

Original Depre-

Tax 5-Year ciationBasis Property on Oldof Old Recovery Machine

Year Machine Rate (1) (2)

1 $10,000 .320 $3,2002 10,000 .192 1,9203 10,000 .115 1,1504 10,000 .115 1,1505 10,000 .058 580

$8,000

(1) (2) (3)Tax

Original Depre-Tax 5-Year ciation

Basis Property on Newof New Recovery Machine

Year Machine Rate (1) (2)

1 $17,000 .200 $3,4002 17,000 .320 5,4403 17,000 .192 3,264

4 17,000 .115 1,9555 17,000 .115 1,9556 17,000 .058 986

$17,000

22-10 Chapter 22

Note that year 1 isactually the secondyear the old prop-erty is depreciated.Therefore, therecovery rate forthe second year isused to computethe amount of

depreciation on theold property in thefirst year of thecapital expenditureproposal.

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Chapter 22 22-11

P22-2(Concluded)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Additional

Annual

Tax

Cost

Increase

Increase

Allow

able

Depreciation

Savings

(Decrease)

(Decrease)

Net

TaxDepreciation

withNew

With

inTaxable

Income

inIncome

Cash

New

Old

Machine

New

Income

Tax

Tax

Inflow

Year

Machine

Machine

(1)(2)

Machine

(4)(3)

Rate

(5)(6)

(4)(7)

1

$3,400

$3,200

$

200

$3,600

$3,400

40%

$1,360

$

2,240

2

5,440

1,920

3,520

3,600

80

40%

32

3,568

3

3,264

1,150

2,114

3,600

1,486

40%

594

3,006

4

1,955

1,150

805

3,600

2,795

40%

1,118

2,482

5

1,955

580

1,375

3,600

2,225

40%

890

2,710

6

986

0

986

3,600

2,614

40%

1,046

2,554

Totalincreaseinperiodiccashinflows..................................................................................................

$16,560

Lessinitialcashoutla

yfornewmachine...............................................................................................

9,000

Increaseincashinflo

wsoverinitialcashoutlay

fornewmachine.....................................................

$

7,560

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P22-3

(1) Cost to purchase valve stem from outside supplier

($20 per unit 80,000 units per year) ....................................... $1,600,000Incremental cost of manufacturing valve stem:Direct materials ($4.50 80,000 units) ..................................... $ 360,000Direct labor (($3.70 $.80) per unit 80,000 units) ................ 232,000Variable factory overhead (($1.70 $.80) per unit

80,000 units) .......................................................................... 72,000

Total incremental costs........................................................ $ 664,000

Total annual costs savings to make rather than buy....................... $ 936,000

(1) (2) (3)Tax

Tax 3-Year DepreciationBasis Property on New

of New Recovery ToolsYear Tools Rate (1) (2)

1 $2,500,000 .333 $ 832,5002 2,500,000 .444 1,110,0003 2,500,000 .148 370,0004 2,500,000 .075 187,500

$2,500,000

22-12 Chapter 22

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Chapter 22 22-13

P22-3(Concluded) (

1)

(2)

(3)

(4)

(5)

(6

)

Increase

Increase

Ne

t

Tax

(Decrease)

(Decrease)

After

-tax

Depreciation

inTaxable

Income

inIncome

Cash

Co

st

onNew

Income

Tax

Taxes

Inflo

ws

Year

Savings

Tools

(1)(2)

Rate

(3)(4)

(1)

(5)

1

$936,000

$

832,500

$

103,500

40%

$

41,400

$

894,600

2

936,000

1,110,000

(174,000)

40%

(69,600)

1,005,600

3

936,000

370,000

566,000

40%

226,400

709,600

4

936,000

187,500

748,500

40%

299,400

636,600

5

936,000

0

936,000

40%

374,400

561,600

Totalperiodicca

shinflowsfrom

annualcostsavings.......................................................

$3,808,000

After-taxdisposalvalueofspecializedtools:

Cashinflowfrom

salvageoftools.................................................................$100,000

Lesstaxons

alvageoftools..........................................................................

40,000

60,000

Totalafter-taxca

shinflowsfrom

makingproduct...............................................................

$3,868,000

(2)Totalafter-taxca

shinflowsfrom

makingproduct(from

part(1)above)

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

$3,868,000

Initialcashoutla

ytopurchasetools.....................................................................................

2,500,000

Excessoftotaln

etafter-taxcashinflowsoverinitialcostofcapitalproject..................

$1,368,000

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22-14 Chapter 22

P22-4

(1)

(2)

(3)

(4)

(5)

(6)

(7)

Inflation-

P

retax

Unadjusted

Adjusted

Annual

A

nnual

Estimated

Estimated

Cash

Annual6%

Cash

Fixed

Cash

Annual

Operating

Inflows

Inflation

Inflows

Lease

In

flows

Year

Revenues

Expenses

(1)(2)

Adjustment

(3)

(4)

Rentals

(5

)(6)

1

$100,000

$40,000

$60,000

(1

+.06)

=1.060

$63,600

$20,000

$43,600

2

120,000

50,000

70,000

(1

+.06)2=1.124

78,680

20,000

58,680

3

140,000

60,000

80,000

(1

+.06)3=1.191

95,280

20,000

75,280

4

140,000

60,000

80,000

(1

+.06)4=1.262

100,960

20,000

80,960

5

140,000

60,000

80,000

(1

+.06)5=1.338

107,040

20,000

87,040

6

140,000

60,000

80,000

(1

+.06)6=1.419

113,520

20,000

93,520

7

140,000

60,000

80,000

(1

+.06)7=1.504

120,320

20,000

100,320

8

140,000

60,000

80,000

(1

+.06)8=1.594

127,520

20,000

107,520

9

120,000

60,000

60,000

(1

+.06)9=1.689

101,340

20,000

81,340

10

100,000

60,000

40,000

(1

+.06)10=1.791

71,640

20,000

51,640

$779,900

(1)

(2)

(3)

TaxBasis

7-Year

Tax

for

Property

Depreciation

Dep

reciable

Recovery

Available

Year

Property

Rate

(1)(2)

1

$20

0,000

.143

$28,600

2

20

0,000

.245

49,000

3

20

0,000

.175

35,000

4

20

0,000

.125

25,000

5

20

0,000

.089

17,800

6

20

0,000

.089

17,800

7

20

0,000

.089

17,800

8

20

0,000

.045

9,000

$200,000

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Chapter 22 22-15

P22-4(Conclude

d)

(1)

(2)

(3)

(4)

(5)

(6)

Increase

Increase

Pretax

(Decrease)

(Decrease)

After-tax

Annual

Tax

inTaxable

Income

inIncome

Cash

Cash

Depreciation

Income

Tax

Taxes

Inflows

Year

Inflows

Available

(1)(2)

Rate

(3)(4)

(1)(5)

1

$

43,600

$28,600

$15,000

4

0%

$6,000

$

37,600

2

58,680

49,000

9,680

4

0%

3,872

54,808

3

75,280

35,000

40,280

4

0%

16,112

59,168

4

80,960

25,000

55,960

4

0%

22,384

58,576

5

87,040

17,800

69,240

4

0%

27,696

59,344

6

93,520

17,800

75,720

4

0%

30,288

63,232

7

100,320

17,800

82,520

4

0%

33,008

67,312

8

107,520

9,000

98,520

4

0%

39,408

68,112

9

81,340

0

81,340

4

0%

32,536

48,804

10

51,640

0

51,640

4

0%

20,656

30,984

Totalafter-taxca

shinflowsfrom

proposed

investment..........................................................

$547,940

Lessinitialinves

tmentcashoutflow.........................................................................................

200,000

Excessoftotala

fter-taxcashinflowsoverinitialcashoutflow.............................................

$347,940

7/28/2019 Ch22SM

16/30

22-16 Chapter 22

P22-5

(1)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

Contri-

NetCash

Cost

bution

Inflow

Savings

Periodic

Unit

Unit

Margin

From

From

NetCash

Estimate

d

Sales

Variable

PerUnit

Sales

Reduced

Inflows

Year

Demand

Price

Cost

(2)(3)

(1)(4)

Maintenance

(5)+(6)

1

1,000

$11

$5

$6

$6,000

$1,500

$7,500

2

1,000

11

5

6

6,000

1,200

7,200

3

1,000

11

5

6

6,000

900

6,900

4

1,000

11

5

6

6,000

600

6,600

5

1,000

11

5

6

6,000

300

6,300

6

1,000

11

5

6

6,000

0

6,000

7

1,000

11

5

6

6,000

0

6,000

Totalperiodiccashinflows.....................................................

$42,000

$4,500

$46,500

7/28/2019 Ch22SM

17/30

P22-5 (Continued)

(1) (2) (3)Adjusted

Estimate ofPeriodic Annual 10% Net CashNet Cash Price-Level Inflows

Year Inflows Adjustment (1) (2)

1 $ 7,500 (1 + .10) = 1.100 $ 8,2502 7,200 (1 + .10)2 = 1.210 8,7123 6,900 (1 + .10)3 = 1.331 9,1844 6,600 (1 + .10)4 = 1.464 9,6625 6,300 (1 + .10)5 = 1.611 10,1496 6,000 (1 + .10)6 = 1.772 10,6327 6,000 (1 + .10)7 = 1.949 11,694

$46,500 $68,283

(1) (2) (3)Depre- 5-Year Taxciable Property Depre-

Recovery Basis of Recovery ciationYear Machine Percentage (1) (2)

1 $40,000 .200 $ 8,0002 40,000 .320 12,8003 40,000 .192 7,680

4 40,000 .115 4,6005 40,000 .115 4,6006 40,000 .058 2,320

$40,000

Chapter 22 22-17

7/28/2019 Ch22SM

18/30

22-18 Chapter 22

P22-5(Concluded) (

1)

(2)

(3)

(4)

(5)

(6

)

Federal

Income

Ne

t

Adju

sted

Taxable

and

Tax

After

-tax

Estim

ateof

Income

State

Payment

Cash

NetCash

Tax

(Loss)

Income

(Reduction)

Inflo

ws

Year

Inflows

Depreciation

(1)(2)

TaxRate

(3)(4)

(1)

(5)

1

$8,250

$8,000

$

250

40%

$

100

$8,150

2

8,712

12,800

(4,088)

40%

(1,635)

10,347

3

9,184

7,680

1,504

40%

602

8,582

4

9,662

4,600

5,062

40%

2,025

7,637

5

10,149

4,600

5,549

40%

2,220

7,929

6

10,632

2,320

8,312

40%

3,325

7,307

7

11,694

0

11,694

40%

4,678

7,016

Totalafter-taxca

shinflowfrom

salesandc

ostsavings....................................................

$56,968

After-taxcashin

flowfrom

salvageatendofeconomiclife:

Cashinflowfrom

salvage(adjustedforexpected10%

inflation)*.............

$11,694

Taxpayableonsalvagesale**.................

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

4,678

7,016

Totalnetafter-taxcashinflowsfrom

thecapitalexpenditure............................................

$63,984

*$6,000estim

atedsalvagevalue1.949

inflationadjustment(10%

for7years)

**Thecashinflowfrom

thesalvagesalea

ttheendoftheprojectwouldbefullytaxablebecaus

ethetax

basisofthemachinewouldbezero(i.e.,themachinewasfullydepreciated).Thus,thetaxon

thecash

inflowfroms

alvagewouldbe$4,678($1

1,69440%).

(2)Totalafter-taxca

shinflowsfrom

thecapitalexpenditure..................................................

$63,984

Lessoriginalinv

estmentcashoutflow.................................................................................

40,000

Excessoftotala

fter-taxcashinflowsoverinitialinvestment............................................

$23,984

7/28/2019 Ch22SM

19/30

P22-6

(1) (2) (3)Inflation-

AdjustedUnadjusted Annual 10% CashCash Price-Level Inflows

Year Inflows Adjustment (1) (2)

1 $15,000 (1 + .10) = 1.100 $16,5002 20,000 (1 + .10)2 = 1.210 24,2003 25,000 (1 + .10)3 = 1.331 33,2754 25,000 (1 + .10)4 = 1.464 36,6005 25,000 (1 + .10)5 = 1.611 40,2756 25,000 (1 + .10)6 = 1.772 44,3007 25,000 (1 + .10)7 = 1.949 48,725

8 20,000 (1 + .10)8 = 2.144 42,8809 15,000 (1 + .10)9 = 2.358 35,370

10 10,000 (1 + .10)10 = 2.594 25,940

(1) (2) (3)Tax 7-Year Tax

Basis of Property DepreciationDepreciable Recovery Available

Year Property Rate (1) (2)

1 $100,000 .143 $ 14,300

2 100,000 .245 24,5003 100,000 .175 17,5004 100,000 .125 12,5005 100,000 .089 8,9006 100,000 .089 8,9007 100,000 .089 8,9008 100,000 .045 4,500

$100,000

Chapter 22 22-19

7/28/2019 Ch22SM

20/30

22-20 Chapter 22

P22-6(Concluded)

(1)

(2)

(3)

(4)

(5)

(6)

Inflatio

n-

In

crease

Increase

Adjust

ed

(Decrease)

(Decrease)

After-ta

x

Annual

Tax

in

Taxable

Income

inIncome

Cash

Cash

Depreciation

Income

Tax

Taxes

Inflows

Year

Inflow

s

Available

(1)(2)

Rate

(3)(4)

(1)(5

)

1

$16,50

0

$14,300

$

2,200

40%

$

880

$15,620

2

24,20

0

24,500

(300)

40%

(120)

24,320

3

33,27

5

17,500

15,775

40%

6,310

26,965

4

36,60

0

12,500

24,100

40%

9,640

26,960

5

40,27

5

8,900

31,375

40%

12,550

27,725

6

44,30

0

8,900

35,400

40%

14,160

30,140

7

48,72

5

8,900

39,825

40%

15,930

32,795

8

42,88

0

4,500

38,380

40%

15,352

27,528

9

35,37

0

0

35,370

40%

14,148

21,222

10

25,94

0

0

25,940

40%

10,376

15,564

Totalperiodicafter-tax

cashinflows............................................................................................

$248,839

After-taxcashinflowfr

om

salvage:

Inflation-adjustedcashinflowfrom

salvage($

2,0002.594)...........................

$5,188

Taxpayableonsal

vage($5,18840%)...............................................................

2,075

3,113

Totalafter-taxcashinflowsfrom

project.....................................................................................

$251,952

Lessinitialinvestment

cashoutflow............................................................................................

100,000

Excessoftotalafter-taxcashinflowsoverinitiali

nvestment...................................................

$151,952

7/28/2019 Ch22SM

21/30

Chapter 22 22-21

P22-7

(1)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Savings

Total

Additional

Net

Inflation-

Savings

fr

om

Savings

Periodi

c

Main-

Periodic

Adjusted

from

Red

uced

from

Savings

tenance

Saving

s

Annual6%

Per

iodic

Reduced

Machine

Reduced

fromCIM

Cost

withCIM

Inflation

Sav

ings

Year

Labor

SetupTime

Inventory

(1)+(2)+

(3)

withCIM

(4)(5

)

Adjustment

(6)

(7)

1

$15,000

$25

,000

$20,000

$60,00

0

$10,000

$50,00

0

(1+.06)=1.060

$53,000

2

25,000

30

,000

25,000

80,00

0

10,000

70,00

0

(1+.06)2=1.124

78,680

3

35,000

35

,000

30,000

100,00

0

10,000

90,00

0

(1+.06)3=1.191

107,190

4

35,000

35

,000

30,000

100,00

0

10,000

90,00

0

(1+.06)4=1.262

113,580

5

35,000

35

,000

30,000

100,00

0

10,000

90,00

0

(1+.06)5=1.338

120,420

6

35,000

35

,000

30,000

100,00

0

10,000

90,00

0

(1+.06)6=1.419

127,710

(1)

(2)

(3)

(4)

(5)

(6)

Inflation-

Adjusted

Tax

Taxable

Tax

Periodic

Net

Periodic

Depreciation

In

come

Effective

Liability

After-tax

Savings

and

(

Loss)

Tax

(Refund)

CashInflows

Year

withCIM

Amortization*

(1

)(2)

Rate

(3)(4)

(1)(5)

1

$53,000

$240,000

$(187,000)

40%

$(74,800)

$

127,800

2

78,680

360,000

(281,320)

40%

(112,528)

191,208

3

107,190

232,000

(124,810)

40%

(49,924)

157,114

4

113,580

155,000

(41,420)

40%

(16,568)

130,148

5

120,420

155,000

(34,580)

40%

(13,832)

134,252

6

127,710

58,000

69,710

40%

27,884

99,826

Totalannualafter-taxs

avingsfrom

investmentin

CIM...............................................................

$840,348

Lessinitialinvestment:

Equipmentcost...............................................................................................

$1,000,000

Softwarecost..................................................................................................

200,000

1,200,000

ExcessofcostofCIMsystem

overafter-taxsavin

gs.................................................................

$(359,65

2)

7/28/2019 Ch22SM

22/30

22-22 Chapter 22

P22-7(Continued)

*

(1)

(2)

(3)

(4)

(5)

(6))

(7)

T

otalTax

Ratefor

5

-year

Tax

Am

ortization

Recovery

MACRS

Tax

Stra

ight-line

Amorti-

and

Property

5-year

Deprec

iation

Software

Amo

rtization

zation

Depreciation

Year

TaxBas

is

Property

(1)

(2)

TaxBasis

Rate

(4)(5)

(3)+(6)

1

$1,000,000

.200

$

200

,000

$200,000

.200

$40,000

$2

40,000

2

1,000,000

.320

320

,000

200,000

.200

40,000

3

60,000

3

1,000,000

.192

192

,000

200,000

.200

40,000

2

32,000

4

1,000,000

.115

115

,000

200,000

.200

40,000

1

55,000

5

1,000,000

.115

115

,000

200,000

.200

40,000

1

55,000

6

1,000,000

.058

58

,000

200,000

.000

0

58,000

$1,000

,000

$200,000

$1,2

00,000

(2)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Inflation-

Inflation-

Tax

Periodic

Adjusted

Adjusted

Net

Depre-

Net

Periodic

LostPeriodic

Periodic

ciation

Taxable

Tax

After-tax

Savings

Contribution

Savings

and

Income

Effective

Liability

Cash

withCIM

MarginSaved

withCIM

Amor-

(Loss)

Tax

(Refund)

Inflows

Yearfrom

Part(1)

withCIM**

(1)+(2)

tization*

(3)(4)

Rate

(5)(6)

(3)(7)

1

$53,000

$212,000

$265,000

$240,000

$25,000

40%

$10,000

$

255,000

2

78,680

224,800

303,480

360,000

(56,520)

40%

(22,608)

326,088

3

107,190

238,200

345,390

232,000

113,390

40%

45,356

300,034

4

113,580

252,400

365,980

155,000

210,980

40%

84,392

281,588

5

120,420

267,600

388,020

155,000

233,020

40%

93,208

294,812

6

127,710

283,800

411,510

58,000

353,510

40%

141,404

270,106

Totalannualafter-taxsavingsfrom

investmentinCIM......................................................................

$1

,727,628

Lessinitialinvestm

entforequipmentandsoftware(from

above)...................................................

1

,200,000

Excessofafter-tax

savingsovercostofCIMs

ystem

withnewinformatio

n...................................

$

527,628

7/28/2019 Ch22SM

23/30

P22-7 (Concluded)

** (1) (2) (3)Inflation-

AdjustedLost PeriodicLost Periodic ContributionContribution Annual 6% Margin SavedMargin Saved Inflation with CIM

Year with CIM Adjustment (1) (2)

1 $200,000 (1 + .06) = 1.060 $212,0002 200,000 (1 + .06)2 = 1.124 224,8003 200,000 (1 + .06)3 = 1.191 238,2004 200,000 (1 + .06)4 = 1.262 252,4005 200,000 (1 + .06)5 = 1.338 267,600

6 200,000 (1 + .06)6 = 1.419 283,800

Chapter 22 22-23

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CASES

C22-1

Some of the factors that affect the decision of whether or not to delay the invest-ment in new cleaning equipment are given below. Each factor can have two sides(i.e., delay versus no delay) depending upon the circumstances involved.(a) Unemployment, inflation rate, and business conditions in general.

Business outlook improvingdo not delay.Business outlook deterioratingdelay.

All of these factors affect the climate for business and should be consid-ered.

(b) Difficulty associated with acquisition and installation of equipment andtraining of operators.

Great difficultydo not delay.

Little difficultydelay.The greater the lead time involved, the sooner the equipment should beacquired so that it is ready when needed.

(c) Extent of operating efficiency improvements.Greatdo not delay.Littledelay.

The greater the efficiency, the less it should be delayed because costs willbe saved even though volume does not increase.

(d) Inflation rate in cost of equipment.Cost of equipment not expected to increase drasticallydelay.Cost of equipment expected to increase drasticallydo not delay.

Company wants to minimize its initial cost outlay.(e) Dependability of present equipment and likelihood of breakdowns.Dependability is gooddelay.Dependability is not gooddo not delay.

Company could defer, or have to go ahead with investment due to conditionof present equipment.

(f) Chance for technological advances in equipment.Gooddelay.No chancedo not delay.

If there is a chance that technological advances will develop in the design ofthe equipment, the company might want to take advantage of the new

design.(g) Ability to obtain market advantage by providing better quality service at

same or lower price.Gooddo not delay.Poor/neutraldelay.

Better service means more customers or justifies higher rates.

22-24 Chapter 22

7/28/2019 Ch22SM

25/30

C22-1 (Concluded)

(h) Competitors plans for obtaining similar equipment and achieving marketadvantage.

High probabilitydo not delay.Low probabilitydelay.Company wants to maintain competitive advantage or meet competition.

(i) Ability to predict timing and increased volume of demand from new or exist-ing customers.

Goodbetter quality of decision; could defer switch longer.Lowless reliable criteria for decision.

The better a company is able to predict new business, the more certain It canbe of its decision and, possibly, the longer it can wait to make a change.

C22-2

Knight is probably correct in her assessment that the proposed capital invest-ment framework grants too much freedom to the divisions. Neoglobes long-runperformance depends on its capital investments. While divisions must havesome responsibility for capital investments for the proposed organization struc-ture to be effective, corporate management must maintain adequate control todirect the future course of the firm. Under the proposed framework, divisionmanagement controls a substantial portion of the capital budget, and in someyears, few funds would be available for investment by corporate managementThe present proposal would reduce corporate managements ability to diminisha product line, and it also would impair managements ability to have adequate

funds available for investment in new businesses.Capital investment procedures should involve both division and corporatemanagements in such a way that division management still should be able toinfluence the future direction of the firm. Such procedures might include classi-fication of capital projects into groups, some of which could be approved by divi-sion management without corporate management study.

An alternative to the Neoglobe capital investment program might have the fol-lowing features:(a) All proposed investment projects would be classified according to their

naturereplacement, cost savings, expansion.(b) Replacement and cost savings projects could be adopted by division man-

agement alone, without approval of corporate management, provided anindividual project did not exceed a specified dollar limit and the total of suchprojects did not exceed another specified dollar limit.The dollar limits wouldreflect the nature and size of each divisions operations.

(c) All expansion projects, or other projects that exceed the dollar limit, wouldbe submitted to corporate management for evaluation and approval.

Chapter 22 22-25

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C22-3

The process of planning for and evaluating long-term commitments of resourcesis normally referred to as capital expenditure planning, evaluating, and control,

or capital budgeting.The capital budget is distinct in that it focuses on the long-term effect of resources committed. Its primary objectives are to provide man-agement with (1) a formal process to chart its future course, (2) a means ofranking and selecting among alternative resource commitments to maximizereturn on investment, and (3) a program for ongoing evaluation of extantresource commitments.

Any significant resource commitment is viewed as a project. Hence, the cap-ital budget is composed of projects, some of which are in process and some ofwhich are proposed. Each project affects significant periods of time in the ongo-ing life of a company. A project often involves the evaluation of alternatives andthe purchase of such assets as property, plant, and equipment. It should also

consider, however, any proposal or program that requires a significant resourcecommitment over an extended period, such as the development of new products,opening new markets, and the design and development of major computer pro-grams.

Once resources have been committed to a particular project, the projectrequires ongoing evaluation; i.e., are the projects objectives being met? If not, itneeds to be evaluated in terms of whether the project should be retained as is,modified if possible, or abandoned.

McAngus can make significant use of capital expenditure planning, evaluat-ing, and control. At the division level, projects will need to be defined in terms ofthose elements of the plant, or operation of the division, over which the manager

has control. On the basis of the facts given, the division manager has authorityto operate his or her plant essentially as if it were an independent company.Hence, anything affecting operations, which has required or will require signifi-cant resource commitment over a significant period of time, should form an inte-gral part of that divisions capital budget. At the top management level, thepresident may view each division as a project, particularly for evaluation pur-poses.The other described activities of top management (investigating and eval-uating such things as new markets, etc.) are projects in the capital budgetingsense. These and other new proposals may be defined, analyzed, and evaluatedusing a variety of available techniques.

C22-4

(1) Arnetts revision of the first proposal described in the case can certainly be con-sidered a violation of the Standards of Ethical Conduct. Arnett discarded the rea-sonable projections and estimates after being questioned and pressured byEarle, and used figures that have only a remote chance of occurring. By doingthis, Arnett violated the standard of objectivity (which requires that the manage-ment accountant communicate information fairly and objectivelyand disclosefully relevant information that could reasonably be expected to influence an

22-26 Chapter 22

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27/30

intended users understanding of the report presented). By altering the analysisArnett also violated the standard of integrity (which requires that the manage-ment accountant (1) refrain from engaging in an activity that would prejudicehisor her ability to carry out the required duties ethically, and (2) communicate unfa

vorableas well as favorable information, professional judgments, and opinions)Arnett also violated the standard of competence (which requires that the man-agement accountant prepare complete and clear reports and recommendationsafter appropriate analysis of relevant and reliable information).

(2) Based on the facts in the case, Earle was certainly in violation of the Standardsof Ethical Conductas a result of pressuring a subordinate to prepare a proposalwith data that were false and misleading. Earle has violated the standards ofcompetence (failed to perform professional duties in accordance with . . . techni-cal standards; and failed to prepare complete and clear reports and reliableinformation), integrity (engaged in an activity that would prejudice his or her abil-ity to carry out required duties ethically, actively or passively subverted the

attainment of the organizations legitimate and ethical objectives, failed to com-municate unfavorable as well as favorable information and professional judg-ments or opinions, and supported activity that would discredit the profession)and objectivity (failed to communicate information fairly and objectively and didnot disclose fully all relevant information that could reasonably be expected toinfluence an intended users understanding of the report presented).

(3) The elements of the projection and estimation process that are compromisedbecause of a predetermined, misleading outcome include:(a) the quality of the base data,(b) the quality of the assumptions used,(c) the probability of the projection occurring, and

(d) the credibility of the people submitting the projection.(4) The internal controls Fore Corporation could implement to prevent unethica

behavior include:(a) approval of all formal capital expenditure proposals by the controller and/or

the board of directors,(b) designating a non-accounting/finance manager to coordinate capital expen-

diture requests and/or segregating duties during the preparation andapproval of capital expenditure requests,

(c) requiring all capital expenditure proposals be reviewed by senior operatingmanagement, which includes the controller, before the proposals are submitted for approval, and

(d) requiring the internal audit staff to review all capital expenditure proposalsor contracting with external auditors to review the proposal if the corpora-tion does not have sufficient personnel.

Chapter 22 22-27

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C22-5

(1) Referring to the specific standards in the IMAs Standards of Ethical Conduct forPractitioners of Management Accounting and Financial Management, the con-

duct of H. Dodge and G. Watson is unethical as discussed below:

(a) H. Dodges first revision of the proposal for the warehouse conversion wasunethical because Dodges actions violate the following standards:

Competence. Although the estimates used in the analysis are based onmanagements judgment, Dodges action in changing reasonable estimatesto remote assumptions is unethical. Management accountants have theresponsibility to prepare complete and clear reports and recommendationsafter appropriate analyses of relevant and reliable information.

Integrity. Dodge has the responsibility to avoid conflicts of interest, refrainfrom subverting the attainment of the organizations legitimate and ethicalobjectives (profitability), and refrain from engaging in or supporting anyactivity that would discredit the profession.

Objectivity. Dodge has the responsibility to communicate information fairlyand objectively and to disclose fully all relevant information that can influ-ence an intended users understanding.

(b) G. Watsons conduct in giving H. Dodge specific instructions on preparingthe second revision of the proposal is unethical because Watsons conductviolates the following specific standards:

Competence. Watson has the responsibility to perform his professionalduties in accordance with relevant technical standards, such as using con-servatism and realistic estimates in the net present value analysis.Management accountants should prepare complete and clear reports andrecommendations after appropriate analyses of relevant and reliable infor-mation.

Confidentiality. Watson should refrain from using or appearing to use confi-dential information acquired in the course of his work for unethical advan-tage for personal gain (saving on commuting time and costs).

Integrity. Watson has the responsibility to advise all parties of any potentialconflict of interest.Watson should refuse any favor (the warehouse reducinghis commuting time) that would appear to influence his actions. Watsonshould communicate unfavorable as well as favorable information and pro-fessional judgments and opinions.

Objectivity. Watson has the responsibility to disclose fully all relevant infor-mation that can influence an intended users understanding of the analysis.

22-28 Chapter 22

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C22-5 (Concluded)

(2) Steps recommended by the Standards of Ethical Conduct for Practitioners oManagement Accounting and Financial Managementthat H. Dodge should follow

in attempting to resolve this situation are as follows:(a) Dodge should first investigate and see if Evans Company has an establishedpolicy for resolving conflict, and if such a policy exists, Dodge should followit.

(b) Since it appears that G. Watson, Dodges superior, is involved, there is noneed to confront Watson or discuss this issue with Watson any furtherDodge should present the situation to the next higher level, the vice presi-dent of finance, for resolution.

(c) if Dodge does not receive any satisfaction, Dodge should continue to suc-cessively higher levels, including the audit committee and the board ofdirectors, if necessary.

(d) Dodge should clarify the concepts of the issue at hand in a confidential discussion with an objective advisor, i.e., a peer.(e) If the situation is still unresolved after exhausting all levels of interna

review, Dodge will have no recourse but to resign and submit an informativememorandum to an appropriate representative of the organization.

(f) Unless legally bound (which does not appear to be the case in this situa-tion), it is inappropriate to communicate this situation to authorities or indi-viduals outside the organization.

(g) Dodge may consult with personal legal counsel.

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(1) By referring to the IMAs Standards of Ethical Conductand taking into consider-ation the specific standards of competence, confidentiality, integrity, and objectivity, L. Forrest should evaluate B. Rollands directives as follows:

Competence. Forrest has a responsibility to present complete and clear reportsand recommendations after appropriate analysis of relevant and reliable infor-mation. Rolland does not wish the report to be complete or clear, and has pro-vided some information that is not totally reliable.

Confidentiality. Forrest should not disclose confidential information outside ofthe organization; but it also appears that Rolland wants to refrain from disclos-ing information to the board of directors that it should know about.

Integrity. Rolland is engaging in activities that could prejudice him from carryingout his duties ethically. In evaluating Rollands directive as it affects ForrestForrest has an obligation to communicate unfavorable as well as favorable information and professional judgments or opinions.

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Objectivity. The responsibility to communicate information fairly and objectively,as well as to disclose fully all relevant information that could reasonably beexpected to influence reports and recommendations presented, is being ham-pered. The board of directors will not have the full scope of information they

should have when they are presented with the analysis.

(2) By referring to the Standards of Ethical Conduct, L. Forrest should take the fol-lowing steps to resolve this situation:(a) Forrest should first investigate and see if IDI has an established policy for

resolution of ethical conflicts and, if so, follow those procedures.(b) If this policy does not resolve the ethical conflict, the next step would be for

Forrest to discuss the situation with his supervisor, Rolland, and see if hecan obtain resolution. One possible solution may be to present a basecase and sensitivity analysis of the investment. Forrest should make it clearto Rolland that he has a problem and is seeking guidance.

(c) If Forrest cannot obtain a satisfactory resolution with Rolland, Forrest couldtake the situation up to the next layer of management, and inform Rollandthat is being done. If this is not satisfactory, Forrest should progress to thenext level, and eventually to all higher levels of management until the issueis resolved (i.e., the president, audit committee, or board of directors).

(d) Since Rolland has instructed him not to discuss the situation with anyoneelse at IDI, Forrest may want to have a confidential discussion with an objec-tive advisor to clarify relevant concepts and obtain an understanding of pos-sible courses of action. Forrest may want to talk to a close professionalfriend or the IMA Ethics Hotline for this purpose.

(e) If Forrest cannot satisfactorily resolve the situation within the organization,

he may resign from the company and submit an informative memo to anappropriate person in IDI (i.e., the president, audit committee, or board ofdirectors).

(f) Forrest may consult with personal legal counsel.

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