1212 Chapter 26 Capital Investment Analysis

Income from Net CashInvestment Year Operations Flow

Proposal D: $180,000 1 $ 54,000 $ 90,0002 24,000 60,0003 24,000 60,0004 14,000 50,0005 14,000 50,000_________ _________

$130,000 $310,000_________ __________________ __________

The company’s capital rationing policy requires a maximum cash payback period

of three years. In addition, a minimum average rate of return of 12% is required on all

projects. If the preceding standards are met, the net present value method and present

value indexes are used to rank the remaining proposals.

Instructions1. Compute the cash payback period for each of the four proposals.2. Giving effect to straight-line depreciation on the investments and assuming no esti-

mated residual value, compute the average rate of return for each of the four pro-posals. Round to one decimal place.

3. Using the following format, summarize the results of your computations in parts (1)and (2). By placing the calculated amounts in the first two columns on the left and byplacing a check mark in the appropriate column to the right, indicate which proposalsshould be accepted for further analysis and which should be rejected.

Cash Payback Average Rate Accept forProposal Period of Return Further Analysis Reject

ABCD

4. For the proposals accepted for further analysis in part (3), compute the net presentvalue. Use a rate of 15% and the present value of $1 table appearing in this chapter.Round to the nearest dollar.

5. Compute the present value index for each of the proposals in part (4). Round to twodecimal places.

6. Rank the proposals from most attractive to least attractive, based on the presentvalues of net cash flows computed in part (4).

7. Rank the proposals from most attractive to least attractive, based on the presentvalue indexes computed in part (5).

8. Based on the analyses, comment on the relative attractiveness of theproposals ranked in parts (6) and (7).

Special Activities

Dawn Jeffries was recently hired as a cost analyst by Carenet Medical Supplies Inc. Oneof Dawn’s first assignments was to perform a net present value analysis for a new ware-house. Dawn performed the analysis and calculated a present value index of 0.75. Theplant manager, I. M. Madd, is very intent on purchasing the warehouse because hebelieves that more storage space is needed. I. M. Madd asks Dawn into his office andthe following conversation takes place:

I. M.: Dawn, you’re new here, aren’t you?

Dawn: Yes, sir.

I. M.: Well, Dawn, let me tell you something. I’m not at all pleased with the capital investment analysisthat you performed on this new warehouse. I need that warehouse for my production. If I don’t get it,where am I going to place our output?

Dawn: Hopefully with the customer, sir.

I. M.: Now don’t get smart with me.

SA 26-1Ethics and profes-sional conduct inbusiness

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Chapter 26 Capital Investment Analysis 1213

Dawn: No, really, I was being serious. My analysis does not support constructing a new warehouse. Thenumbers don’t lie, the warehouse does not meet our investment return targets. In fact, it seems to methat purchasing a warehouse does not add much value to the business. We need to be producing productto satisfy customer orders, not to fill a warehouse.

I. M.: Listen, you need to understand something. The headquarters people will not allow me to build thewarehouse if the numbers don’t add up. You know as well as I that many assumptions go into your net present value analysis. Why don’t you relax some of your assumptions so that the financial savings will off-set the cost?

Dawn: I’m willing to discuss my assumptions with you. Maybe I overlooked something.

I. M.: Good. Here’s what I want you to do. I see in your analysis that you don’t project greater sales as aresult of the warehouse. It seems to me, if we can store more goods, then we will have more to sell.Thus, logically, a larger warehouse translates into more sales. If you incorporate this into your analysis, Ithink you’ll see that the numbers will work out. Why don’t you work it through and come back with a newanalysis. I’m really counting on you on this one. Let’s get off to a good start together and see if we can getthis project accepted.

What is your advice to Dawn?

A Masters of Accountancy degree at Mid-State University would cost $10,000 for an

additional fifth year of education beyond the bachelor’s degree. Assume that all tuition

is paid at the beginning of the year. A student considering this investment must evalu-

ate the present value of cash flows from possessing a graduate degree versus holding

only the undergraduate degree. Assume that the average student with an undergradu-

ate degree is expected to earn an annual salary of $46,000 per year (assumed to be paid

at the end of the year) for 10 years. Assume that the average student with a graduate

Masters of Accountancy degree is expected to earn an annual salary of $57,000 per year

(assumed to be paid at the end of the year) for nine years after graduation. Assume a

minimum rate of return of 10%.

1. Determine the net present value of cash flows from an undergraduate degree. Usethe present value tables provided in this chapter.

2. Determine the net present value of cash flows from a Masters of Accountancydegree, assuming no salary is earned during the graduate year of schooling.

3. What is the net advantage or disadvantage of pursuing a graduate degreeunder these assumptions?

SA 26-2Personal investmentanalysis

International Electronics Inc. invested $1,000,000 to build a plant in a foreign country.

The labor and materials used in production are purchased locally. The plant expansion

was estimated to produce an internal rate of return of 20% in U.S. dollar terms. Due to

a currency crisis, the currency exchange rate between the local currency and the U.S.

dollar doubled from two local units per U.S. dollar to four local units per U.S. dollar.

a. Assume that the plant produced and sold product in the local economy. Explainwhat impact this change in the currency exchange rate would have on the project’sinternal rate of return.

b. Assume that the plant produced product in the local economy but exported theproduct back to the United States for sale. Explain what impact the change in thecurrency exchange rate would have on the project’s internal rate of return under thisassumption.

SA 26-3Changing prices

The following are some selected quotes from senior executives:

CEO, Worthington Industries (a high technology steel company): “We try to find the besttechnology, stay ahead of the competition, and serve the customer. . . . We’ll make any invest-ment that will pay back quickly . . . but if it is something that we really see as a must down theroad, payback is not going to be that important.”

Chairman of Amgen Inc. (a biotech company): “You cannot really run the numbers, do netpresent value calculations, because the uncertainties are really gigantic . . . You decide on a proj-ect you want to run, and then you run the numbers [as a reality check on your assumptions].Success in a business like this is much more dependent on tracking rather than on predicting,

SA 26-4Qualitative issues ininvestment analysis

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1214 Chapter 26 Capital Investment Analysis

much more dependent on seeing results over time, tracking and adjusting and readjusting, muchmore dynamic, much more flexible.”

Chief Financial Officer of Merck & Co., Inc. (a pharmaceutical company): “ . . . at the indi-vidual product level—the development of a successful new product requires on the order of $230million in R&D, spread over more than a decade—discounted cash flow style analysis does not become a factor until development is near the point of manufacturing scale-up effort. Priorto that point, given the uncertainties associated with new product development, it would belunacy in our business to decide that we know exactly what’s going to happen to a product onceit gets out.”

Explain the role of capital investment analysis for these companies.

Metro-Goldwyn-Mayer Studios Inc. (MGM) is a major producer and distributor of the-

atrical and television filmed entertainment. Regarding theatrical films, MGM states,

“Our feature films are exploited through a series of sequential domestic and interna-

tional distribution channels, typically beginning with theatrical exhibition. Thereafter,

feature films are first made available for home video generally six months after theatri-

cal release; for pay television, one year after theatrical release; and for syndication,

approximately three to five years after theatrical release.”

Assume that MGM produces a film during early 2011 at a cost of $195 million, and

releases it halfway through the year. During the last half of 2011, the film earns rev-

enues of $235 million at the box office. The film requires $50 million of advertising dur-

ing the release. One year later, by the end of 2012, the film is expected to earn MGM net

cash flows from home video sales of $36 million. By the end of 2013, the film is expect-

ed to earn MGM $43 million from pay TV; and by the end of 2014, the film is expected

to earn $12 million from syndication.

a. Determine the net present value of the film as of the beginning of 2011 if the desiredrate of return is 20%. To simplify present value calculations, assume all annual netcash flows occur at the end of each year. Use the table of the present value of$1 appearing in Exhibit 1 of this chapter. Round to the nearest whole million dollars.

b. Under the assumptions provided here, is the film expected to be financiallysuccessful?

SA 26-5Net present valuemethod

In one group, find a local business, such as a copy shop, that rents time on desktop com-

puters for an hourly rate. Determine the hourly rate. In the other group, determine the

price of a mid-range desktop computer at http://www.dell.com. Combine this informa-

tion from the two groups and perform a capital budgeting analysis. Assume that one

student will use the computer for 40 hours per semester for the next three years. Also

assume that the minimum rate of return is 10%. Use the interest tables in Appendix A

in performing your analysis. (Hint: Use the appropriate present value factor for 5%

compounded for six semiannual periods.)

Does your analysis support the student purchasing the computer?

SA 26-6Capital investmentanalysis

Internet Project

Group Project

Answers to Self-Examination Questions

1. C Methods of evaluating capital investment pro-posals that ignore the time value of moneyinclude the average rate of return method (answerA) and the cash payback method (answer B).

2. B The average rate of return is 24% (answer B),determined by dividing the expected average

annual earnings by the average investment, asfollows:

$60,000>5

[1$100,0002 + 0]>2= 24%

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