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CHAPTER 11

CAPITAL BUDGETING
The following tables are needed to complete problems requiring present value
computations. Students may also use a calculator or computer spreadsheet program, but the
answers to the multiple choice may change due to rounding errors.
Warning: Two comprehensive problems are prefaced by (Additional PV information is needed to
complete this problem.) when these tables are insufficient for completion.

Period

5
10
20
Period

5
10
20

5%
0.7835
0.6139
0.3769

5%
1.2763
1.6289
2.6533

Present value of $1
10%
15%
20%
0.6209
0.3855
0.1486

0.4972
0.2472
0.0611

Present value of an annuity of $1


Period
5%
10%
15% 20%
5
4.3295
3.7908
3.3522 2.9906
10
7.7217
6.1446
5.0188 4.1925
20
12.4622
8.5136
6.2593 4.8696

0.4019
0.1615
0.0261

Future value of $1
10%
15%
20%
1.6105
2.5937
6.7275

2.0114
4.0456
16.3665

Annuity required to repay an amount of $1


Period
5%
10%
15% 20%
5
0.2310
0.2638
0.2983 0.3344
10
0.1295
0.1627
0.1993 0.2385
20
0.0802
0.1175
0.1598 0.2054

2.4883
6.1917
38.3376

TRUE/FALSE
1.

Employee training costs should be evaluated as long-term investments.


a.
True
b.
False

2.

Long-term asset acquisitions are evaluated to determine whether future benefits justify the
initial cost.
a.
True
b.
False

3.

Money received in the future is more valuable than it is now.


a.
True
b.
False

4.

Robert wants to invest in a certificate of deposit that pays out $4,000 in four years. If
interest rates increase, the required initial investment will also increase.
a.
True
b.
False

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5.

The future value of $100 is greater than its present value.


a.
True
b.
False

6.

Future value is calculated for time zero.


a.
True
b.
False

7.

A bond that pays 8% interest will sell at a premium in a 10% market.


a.
True
b.
False

8.

The cost of capital reflects the degree of financial and operating risk to the organization.
a.
True
b.
False

9.

If a companys cost of capital is 15%, a net present value of $10 indicates an acceptable
capital project.
a.
True
b.
False

10.

Choosing the greatest net present value is always the best decision choice.
a.
True
b.
False

11.

When using net present value and a 12% discount rate results in an acceptable project, then
a 9% discount rate will also result in that same project being acceptable.
a.
True
b.
False

12.

The net present value method is considered superior to the internal rate of return for
evaluating capital projects.
a.
True
b.
False

13.

The internal rate of return method assumes the organization can reinvest a projects
intermediate cash flows at the projects internal rate of return.
a.
True
b.
False

14.

The payback method does not consider the time value of money and, therefore, is rarely
used in practice.
a.
True
b.
False

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15.

If a companys cost of capital is 12%, a net present value of $1 indicates the projects actual
rate of return exceeds 12%.
a.
True
b.
False

16.

The profitability index provides comparison information for projects with different initial
investments.
a.
True
b.
False

17.

Economic value added is best suited for evaluating new capital projects.
a.
True
b.
False

18.

Depreciation reduces income and, therefore, helps reduce the income taxes of an
organization.
a.
True
b.
False

19.

To account for inflation, discount the cash flow by the appropriate discount rate and the
expected inflation rate.
a.
True
b.
False

20.

Capital budgeting estimates are usually more accurate for new projects.
a.
True
b.
False

21.

If a capital project is projected to return less than the cost of capital, it may still be
implemented for strategic reasons.
a.
True
b.
False

22.

Post-implementation audits help ensure planning groups use reasonable estimates.


a.
True
b.
False

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MULTIPLE CHOICE
23.

The purchase of long-term assets results in all of the following EXCEPT:


a.
the creation of committed resources
b.
the creation of unit-related costs
c.
additional risk for the organization
d.
reduced organizational flexibility

24.

An organization must approach long-term investments cautiously because of all of the


following EXCEPT that:
a.
the long-term nature creates technological risk
b.
invested amounts are committed for an extended period of time
c.
the value of money decreases with time
d.
a large amount of capital is usually invested

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 25 THROUGH 27.


Carol invests $10,000 in a 2-year certificate of deposit (CD) that will earn a 6% annual rate of
return compounded annually.
25.

At the end of the two years, the future value of the CD is:
a.
$10,000
b.
$10,600
c.
$11,200
d.
$11,236

26.

The rate of return on this investment is:


a.
6%
b.
12%
c.
12.36%
d.
None of the above is correct.

27.

The difference between the present value and the future value of this investment is:
a.
the annuity of the investment
b.
interest earned on the investment
c.
the investment rate of return
d.
the cash inflows from the investment

28.

For the purchase of a boat, motor, and trailer, Steven needs to accumulate $25,000 at the
end of two years. His initial investment will earn 8% annual interest compounded
semiannually. For this investment:
a.
the number of compounding periods is 2
b.
the interest earned per compounding period is 4%
c.
$25,000 is the present value
d.
the rate of return is 16%

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29.

Investments A and B both have a future value of $5,000 and are exactly the same except that
Investment A has a 5% rate of return while Investment B has an 8% rate of return. The
present value of Investment A will be __________ the present value of Investment B.
a.
less than
b.
the same as
c.
greater than
d.
cant tell

30.

Investments A and B both have a future value of $5,000 and are exactly the same except that
Investment A matures in 5 years while Investment B matures in ten years. The present value
of Investment A will be __________ the present value of Investment B.
a.
less than
b.
the same as
c.
greater than
d.
cant tell

31.

A lottery pays the winner $100,000 per year for 20 years. The present value of this prize
money is:
a.
greater than $2,000,000
b.
$2,000,000
c.
less than $2,000,000
d.
indeterminable

32.

The cost of capital:


a.
reflects the perceived level of risk that investors require
b.
is used to calculate the accounting rate of return
c.
is used to calculate future value
d.
is another term for the rate of return

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 33 AND 34.


An investor wants to have $25,000 in an account at the end of 25 years. At current interest rates,
$5,000 needs to be deposited now to reach the goal of $25,000.
33.

What is the present value of this investment?


a.
$1,000
b.
$5,000
c.
$25,000
d.
More information is needed to determine the amount.

34.

Assume interest rates increase before the investment is made. To reach the same goal of
$25,000 in 25 years, the investor will have to deposit:
a.
more than $5,000
b.
$5,000
c.
less than $5,000
d.
More information is needed to determine the amount of the deposit.

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35.

You have been offered the following two annuities for the same price: Annuity 1 pays
$20,000 per year for 10 years; and Annuity 2 pays $40,000 per year for 5 years. Which of
these two annuities offers a greater value?
a.
They are of equal value because both pay $200,000 over the life of the annuity.
b.
Annuity 2 is of greater value because the payments are received sooner.
c.
Annuity 1 is of greater current value because the payments are received over a longer
period of time.
d.
The value cannot be determined without proper present value analysis.

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 36 THROUGH 39.


A bond with a face value of $10,000 pays $600 in interest every six months for 10 years and a
lump sum of $10,000 at the end of the tenth year. The current market requires 10% interest
compounded semiannually.
36.

What is the present value of the $10,000 payment at the end of the tenth year?
a.
$ 1,486
b.
$ 3,769
c.
$ 3,855
d.
$61,446

37.

The $600 semiannual interest payments:


a.
are an example of an annuity
b.
have a present value of $12,000
c.
reflect the actual rate of interest received by the investor
d.
are all paid at time zero

38.

What is the present value of the $600 semiannual interest payments?


a.
$12,000
b.
$3,687
c.
$4,626
d.
$7,477

39.

What would an investor be willing to pay now for this $10,000 bond?
a.
More than $10,000
b.
$10,000
c.
Less than $10,000
d.
More information is needed to determine the amount.

40.

All of the following use the time value of money to evaluate long-term investments
EXCEPT:
a.
the payback method
b.
the net present value method
c.
the internal rate of return
d.
the profitability index

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41.

Assume a capital project requires $42,000 as an initial investment and expects a net cash
inflow of $12,000 per year. The payback period method:
a.
would consider the capital project acceptable if the company requires a minimum
payback period of three years
b.
is usually used as a screening device to eliminate capital projects from further
investigation
c.
uses accounting net income rather than cash flows in the calculations
d.
compares the rate of return to the companys cost of capital

42.

The accounting rate of return:


a.
considers the time value of money
b.
ignores cash outflows after the initial investment
c.
incorporates the timing of cash flows
d.
utilizes depreciation for the calculation of average income

43.

The net present value (NPV) capital budgeting decision method:


a.
can be directly compared between alternatives
b.
incorporates the time value of money in the calculations
c.
is based on accounting net income
d.
indicates an acceptable capital project with a negative value

44.

A net present value of $1,000:


a.
indicates the capital projects rate of return exceeds the companys cost of capital
b.
for one project is considered superior to another project with a net present value of
$500
c.
indicates the internal rate of return would be unacceptable
d.
indicates cash inflows total $1,000 for the capital project

45.

Project A: present value (PV) of the cash inflows is $55,000 and the PV of the cash
outflows is $50,000. Project B: PV of the cash inflows is $24,000 and the PV of the cash
outflows is $20,000. All of the following are true EXCEPT:
a.
the net present value of Project A is $5,000
b.
the net present value of Project B is $4,000
c.
the profitability index for Project A is 1.1
d.
Project A is a better investment than Project B

46.

A 16% internal rate of return (IRR) indicates all of the following EXCEPT:
a.
the actual rate of return of all cash inflows and outflows
b.
that a 16% discount rate will result in the calculation of a net present value of zero
c.
a better indication of acceptable capital projects when there is limited capital than the
net present value method
d.
an acceptable capital project if the cost of capital is 12%

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47.

Which of the following indicates an UNACCEPTABLE capital project?


a.
The internal rate of return exceeds the cost of capital.
b.
The net present value of a project is 10.
c.
The profitability index of a project is 0.97.
d.
The accounting rate of return exceeds the target rate of return.

48.

__________ is best for comparing mutually exclusive projects of different sizes.


a.
The payback method
b.
The net present value method
c.
The internal rate of return
d.
The profitability index

49.

Economic value added:


a.
is most widely used to evaluate new capital investments
b.
in practice is similar to net present value but it uses accounting income rather than
cash flows in the evaluation
c.
determines the actual rate of return of all cash inflows and outflows
d.
is similar to the internal rate of return but it corrects for the conservative bias

50.

Hitz Corporation is financed 60% by debt with a pretax cost of 10%, and 40% by common
equity with a pretax cost of 15%. Hitz Corporations marginal tax rate is 50%. Hitzs
weighted average cost of capital is:
a.
9.0%
b.
10.0%
c.
12.0%
d.
12.5%

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 51 THROUGH 55.


Crittenden Company is considering two mutually exclusive investments in capital equipment that
have a 10% cost of capital. Cash flow information for the two alternatives is below.
Initial investment in equipment
Increase in annual cash flows
Life of equipment
Salvage value of equipment
51.

Investment 1
$110,000
$ 20,000
10 years
0

Investment 2
$170,000
$ 30,000
10 years
0

Determine the present value of the initial investment for each alternative.
a.
$42,405 and $65,535
b.
$675,906 and $1,044,582
c.
$1,700,000 and $1,100,000
d.
None of the above is correct.

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52.

Determine the present value of the annual cash flows for each alternative.
a.
$7,710 and $11,565
b.
$20,000 and $30,000
c.
$122,892 and $184,338
d.
$200,000 and $300,000

53.

Compute the net present value for each investment.


a.
$12,892 and $14,338
b.
$90,000 and $140,000
c.
$67,591 and $104,465
d.
None of the above is correct.

54.

Compute the profitability index for each investment.


a.
0.895 and 0.922
b.
1.117 and 1.084
c.
5.500 and 5.667
d.
None of the above is correct.

55.

Which investment would you recommend?


a.
investment 1 because of the lower initial investment
b.
investment 2 because of the greatest annual cash flows
c.
investment 1 because of the greatest profitability index
d.
investment 2 because of the greatest net present value

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 56 AND 57.


Consider the following two mutually exclusive projects, each of which requires an initial
investment of $30,000 and both provide cash inflows of $60,000 as shown below. This
organization has a 15% cost of capital.
Year
Project A
Project B
0
($30,000)
($30,000)
1
$30,000
$10,000
2
20,000
20,000
3
10,000
30,000
56.

Using the payback criterion, which is the most desirable project?


a.
Project A
b.
Project B
c.
Both projects A and B are equally acceptable.
d.
Neither project A or B is acceptable.

57.

Using the net present value criterion, which is the most desirable project?
a.
Project A
b.
Project B
c.
Both projects A and B are equally acceptable.
d.
The desirability cannot be determined using the current information.

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THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 58 AND 59.


Davidson Company is now investigating three mutually exclusive investment opportunities. The
companys cost of capital is 10 percent. Information on the three investment projects under study
is given below:
----1-------2-------3---Initial investment
$(40,000) $(36,000) $(45,000)
Net present value
$(2,024)
$7,340
$7,297
Profitability index
0.95
1.20
1.10
Internal rate of return
8%
14%
19%
Life of the project
5 yrs
12 yrs
3 yrs
Davidson Company has limited funds available for investment and, therefore, it cant accept all of
the projects listed above.
58.

Which projects are acceptable to Davidson?


a.
investment 2
b.
investment 3
c.
investment 2 and 3
d.
investment 1, 2, and 3

59.

Which single investment do you recommend of these three mutually exclusive projects?
a.
investment 1
b.
investment 2
c.
investment 3
d.
All of these investments could be recommended.

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 60 THROUGH 65.


During 2005, a franchise-owned restaurant averaged:
$300,000 in sales;
$50,000 in net cash flows; and
$30,000 in operating income.
The expected cash investment per franchise-owned restaurant opening in the year 2005 was
$250,000. Assume the value of the investment decreases to zero over a ten-year period of time.
60.

The payback period for one franchise-owned restaurant is:


a.
5.0 years
b.
8.4 years
c.
6.0 years
d.
10.0 years

61.

The accounting rate of return for one franchise-owned restaurant is:


a.
0.12
b.
0.24
c.
0.10
d.
0.20

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62.

Assuming a 10 % required rate of return, the net present value for one franchise-owned
restaurant is:
a.
$19,275
b.
$11,565
c.
($65,662)
d.
$57,230

63.

The profitability index for one franchise-owned restaurant is:


a.
1.667
b.
0.737
c.
1.229
d.
0.813

64.

The internal rate of return for one franchise-owned restaurant is:


a.
approximately 15%
b.
10%
c.
greater than 20%
d.
The IRR cannot be determined.

65.

Does this franchise-owned restaurant appear to be a good investment?


a.
No, because the payback period is too long.
b.
No, because the expected net annual cash inflows are inadequate.
c.
Yes, because the investment delivers more than the 10% required rate of return.
d.
Yes, because the accounting rate of return is greater than 10%.

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 66 THROUGH 71.


During 2005, a franchise-owned restaurant averaged:
$200,000 in sales;
$75,000 in net cash flows; and
$20,000 in operating income.
The expected cash investment per franchise-owned restaurant opening in the year 2005 was
$500,000. Assume the value of the investment decreases to zero over a ten-year period of time.
66.

The payback period for one franchise-owned restaurant is:


a.
6.67 years
b.
2.67 years
c.
3.75 years
d.
10.0 years

67.

The accounting rate of return for one franchise-owned restaurant is:


a.
0.04
b.
0.08
c.
0.10
d.
0.40

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68.

Assuming a 10 % required rate of return, the net present value for one franchise-owned
restaurant is:
a.
$7,710
b.
$260,845
c.
($377,108)
d.
($39,155)

69.

The profitability index for one franchise-owned restaurant is:


a.
2.304
b.
0.434
c.
0.922
d.
1.085

70.

The internal rate of return for one franchise-owned restaurant is:


a.
between 5% and 10%
b.
10%
c.
greater than 20%
d.
The IRR cannot be determined

71.

Does this franchise-owned restaurant appear to be a good investment?


a.
Yes, because the payback period is less than ten years.
b.
Yes, because the expected net annual cash inflows provide a good salary.
c.
No, because the investment delivers less than the 10% required rate of return.
d.
No, because the accounting rate of return is less than 10%.

72.

Taxes of an organization:
a.
are increased as a result of depreciation
b.
affect lump-sum payments but not annuities
c.
can best be analyzed by using pretax cash flows
d.
usually increase when the net benefit of an investment increases

73.

All of the following are true regarding capital budgeting EXCEPT that:
a.
estimates are not always realized
b.
estimating future cash flows is relatively easy
c.
most estimates are extended projections of past cash flow information
d.
estimating circumstances not previously experienced is the hardest

74.

The primary use of sensitivity analysis is to determine:


a.
the effects of a change in a parameter on a decision
b.
if the project is too risky to undertake
c.
the effect of adding or dropping a product line
d.
which planners make poor estimates

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75.

Strategic considerations:
a.
are fairly easy to determine
b.
evaluate a firms competitive edge
c.
should not override capital budgeting analysis results
d.
are decreasing in importance

76.

Post-implementation audits are all of the following EXCEPT they:


a.
are useful to identify how future estimates can be improved
b.
help ensure planning estimates are reasonable
c.
are required by a companys external auditors
d.
are conducted after a project has been implemented

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REMINDER!!! Present value tables that are needed to answer the multiple choice questions
are located at the beginning of this chapter.
EXERCISE/PROBLEM
77.

An investor wants to have $20,000 in an account at the end of 20 years. At current interest
rates, $7,000 needs to be deposited now to reach the goal of $20,000.
a.
What is the present value of this investment?
b.
Assume interest rates decrease before the investment is made. Will an investment of
$7,000 still result in $20,000 in 20 years? Why or why not?

78.

You have been offered the following two annuities for the same price: Annuity 1 pays
$50,000 per year for 10 years; and Annuity 2 pays $25,000 per year for 20 years. Which of
these two annuities is a better deal? Why?

79.

A lottery pays the winner $50,000 per year for 20 years.


a.
Is the winner receiving a $1,000,000 value? Why or why not?
b.
Is the winner receiving an annuity? How can you tell?
c.
Compute the present value of the prize money assuming a 5% discount rate. Explain
what this amount indicates.

80.

A bond with a face value of $25,000 pays $1,000 in interest every six months for 10 years
and a lump sum of $25,000 at the end of the tenth year. The current market requires 10%
interest compounded semiannually.
a.
What would an investor be willing to pay now for
1.
the $25,000 at the end of the tenth year?
2.
the $1,000 semiannual interest payments?
3.
the $25,000 bond?
b.
Is this bond selling at a premium or a discount? Why?

81.

Hitz Corporation is financed 70% by debt with a pretax cost of 10%, and 30% by common
equity with a pretax cost of 18%. Hitz Corporations marginal tax rate is 40%.
a.
Calculate Hitzs weighted average cost of capital.
b.
How might the cost of capital be used for decision making at Hitz Corporation?

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82.

Crittenden Company is considering two mutually exclusive investments in capital equipment


that have a 10% cost of capital. Cash flow information for the two alternatives is below.
Investment 1
Investment 2
Initial investment in equipment
$210,000
$135,000
Increase in annual cash flows
$ 60,000
$ 40,000
Life of equipment
5 years
5 years
Salvage value of equipment
0
0
a.
b.
c.
d.
e.

83.

Stevens Company is contemplating the purchase of a corporate jet. This jet could be either
purchased or rented from the manufacturer. The length of the purchase contract is five
years. If the jet is purchased, Stevens could sell it at the end of five years for $600,000. The
companys cost of capital is 20%. The data concerning these two alternatives are as follows:
Purchase
Rent
Purchase price
$820,000
-Annual cash payments for servicing and licenses
40,000
-Depreciation each year
44,000
-Salvage value at the end of year 5
600,000
-Estimated annual rental payments
-$250,000
a.
b.

84.

Determine the present value of the initial investment for each alternative.
Determine the present value of the annual cash flows for each alternative.
Compute the net present value for each investment.
Compute the profitability index for each investment.
Which investment would you recommend? Why?

Compute the net present value of both alternatives.


Which is the better alternative? Why?

Roberts Manufacturing is considering purchasing a piece of equipment costing $65,000,


which would create a net cash inflow of $40,000 for five years. The companys cost of
capital is 10% and the tax rate is 40%.
Initial investment in equipment
Increase in annual cash flows
Life of equipment
Salvage value of equipment
a.
b.

$65,000
$40,000
5 years
0

Assuming the company uses straight-line depreciation for tax purposes, what is the net
present value of purchasing the new equipment, taking income taxes into account?
Should Roberts consider this purchase? Why or why not?

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85.

Consider the following two mutually exclusive projects, each of which require an initial
investment of $100,000 and have no salvage value. This organization, which has a cost of
capital of 15%, must choose one or the other.
Year
1
2
3
4
5
a.
b.
c.
d.
e.

86.

Project A
$10,000
20,000
30,000
40,000
50,000

Project B
$50,000
40,000
30,000
20,000
10,000

Compute the payback period of these two projects. Using the payback criterion,
which project is more desirable?
What are the advantages and drawbacks of using the payback period criterion to select
a capital investment alternative?
Straight-line depreciation is used to compute income. Compute the accounting rate of
return for these two projects. Using the accounting rate of return criterion, which
project is more desirable?
What are the advantages and drawbacks of using the accounting rate of return
criterion to select a capital investment alternative?
Which is the better investment? Why?

Davidson Company is now investigating five different investment opportunities. The


companys cost of capital is 10 percent. Information on the five investment projects under
study is given below:
----1-------2-------3-------4---- ----5---Initial investment
$(48,000) $(36,000) $(27,000) $(45,000) $(40,000)
Present value of cash inflows
at a 10% discount rate
56,727
43,340
33,614
52,297
37,976
Internal rate of return
16%
14%
18%
19%
8%
Life of the project
6 yrs
12 yrs
6 yrs
3 yrs
5 yrs
Davidson Company has limited funds available for investment and, therefore, cant accept all
of the projects listed above.
a.
b.
c.
d.

e.

Compute the net present value for each investment project.


Compute the profitability index for each investment project.
Which projects are acceptable to Davidson? Why?
Rank the five projects according to preference in terms of:
1.
net present value;
2.
profitability index; and
3.
internal rate of return.
Which investment do you recommend? Why?

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87.

(Additional PV information is needed to complete this problem.) Papa Johns International,


Inc., has surpassed Little Caesars to become the Number 3 pizza chain, behind Pizza Hut
and Domino's, with more than 2,300 restaurants scattered across the U.S. and five other
countries. Most restaurants offer delivery or take-out only.
The following information was reported by Papa Johns on the Form 10-K for the fiscal year
ended December 26, 1999: For a company-owned restaurant average sales were $754,000;
average cash flows were $154,000; and average operating income was $128,000. The
expected cash investment per company-owned restaurant opening in the year 2000 is
$244,000. Assume the value of the investment decreases to zero over a ten-year period of
time.
For one company-owned Papa Johns restaurant, compute the:
a.
payback period;
b.
accounting rate of return;
c.
net present value assuming a 16% required rate of return; and
d.
internal rate of return.
e.

88.

Does a Papa Johns company-owned restaurant appear to be a good investment? Why


or why not?

(Additional PV information is needed to complete this problem.)


Truro Winery is considering the following investment opportunity in a new machine to make
Golden Glow, its new apple cider. The investment required is $14,000,000 at the start of
year 1 and $10,000,000 at the start of year 2. Starting at the end of year 2, the machine will
provide incremental cash inflows of $8,000,000 per year for 12 years. The annual operating
expenses associated with the machine will be $3,000,000 each year. If the Truro Winery's
after-tax cost of capital is 12% and its marginal tax rate is 30%, compute the following:
a.
b.
c.
d.

payback;
accounting rate of return (assuming straight-line depreciation);
net present value; and
internal rate of return.

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CRITICAL THINKING/ESSAY
89.

Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate


investments in long-term assets. Why do these assets deserve this attention?

90.

Some people believe that discounted cash flow analysis discriminates against long-term
projects because it heavily penalizes cash flows that occur well into the future. Comment.

91.

Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%
discount rate to evaluate capital project XYZ?

92.

Explain the profitability index and the payback methods used in capital budgeting. Discuss
when it would be most appropriate to use each.

93.

List two capital budgeting methods that utilize the time value of money and explain how
each ranks the performance of different alternatives.

94.

Explain how the internal rate of return criterion, if improperly applied, can cause managers
to make inappropriate investment decisions.

95.

You are considering an investment in a new restaurant chain. You have developed estimates
of the initial investment required and the cash flows from that investment. However, you
are wondering about the risk of your investment. How might you assess the impact of
estimates in your investment decision?

96.

An organization is considering investing in an employee-training program. The


organization's planners expect that this training program, which would cost $5,000,000, will
reduce manufacturing costs and increase the quality of the company's various products.
How would you frame this decision in the capital budgeting context?

97.

An organization's planners have received a proposal from a manufacturing group to invest in


a new production line. The planners are suspicious that the proposal reflects the group's
interest in acquiring the latest technology rather than reflecting sound economic evaluation.
How might the planners deal with this situation?

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98.

Officials at Dundas Manufacturing have just completed a post-implementation audit of a


distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group
had proposed the warehouse investment arguing that it would improve sales by increasing
product quality and improving customer service. The expected rate of return on this
investment was 18%, however, the actual return on this investment to date has fallen far
below this estimate and it is even below the company's cost of capital of 11%. The postimplementation audit concluded that the managers proposing this investment were
ambitious, to the point of being reckless, in making the estimates underlying the project's
proposals and argued that the investment should never have been made.
In response, the two managers who proposed the project argue that the proposal was a
good one based on estimates that seemed sound at the time. However, several
uncontrollable events, including the entry of a new competitor into the market, caused
results to be lower than expected. Moreover, the two managers argue that results would
have been even worse for the company if the investment had not been made. How would
you deal with this situation?

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CHAPTER 11

SOLUTIONS

CAPITAL BUDGETING

TRUE/FALSE

MULTIPLE CHOICE

LO1
LO3
LO3
LO3
LO3

1.
2.
3.
4.
5.

a
a
b
b
a

LO3
LO3
LO3
LO4
LO4

6.
7.
8.
9.
10.

b
b
a
a
b

LO4
LO4
LO4
LO4
LO4

11.
12.
13.
14.
15.

b
a
a
b
a

LO4
LO4
LO5
LO5
LO6

16.
17.
18.
19.
20.

a
b
a
a
b

LO7
LO8

21.
22.

a
a

AKY 4E Test Bank

LO1
LO2
LO3

23.
24.
25.

b
c
d

LO3
LO3
LO3
LO3
LO3

26.
27.
28.
29.
30.

a
b
b
c
c

LO3
LO3
LO3
LO3
LO3

31.
32.
33.
34.
35.

c
a
b
c
b

LO3
LO3
LO3
LO3
LO4

36.
37.
38.
39.
40.

b
a
d
a
a

LO4
LO4
LO4
LO4
LO4

41.
42.
43.
44.
45.

b
d
b
a
d

LO4
LO4
LO4
LO4
LO4

46.
47.
48.
49.
50.

c
c
d
b
a

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LO4
LO4
LO4
LO4
LO4

51.
52.
53.
54.
55.

d
c
a
b
c

LO4
LO4
LO4
LO4
LO4

56.
57.
58.
59.
60.

a
a
c
b
a

LO4
LO4
LO4
LO4
LO4

61.
62.
63.
64.
65.

b
d
c
a
c

LO4
LO4
LO4
LO4
LO4

66.
67.
68.
69.
70.

a
b
d
c
a

LO4
LO5
LO6
LO6
LO7

71.
72.
73.
74.
75.

c
d
b
a
b

LO8

76.

Schoenebeck

MULTIPLE CHOICE
25.
36.
38.
45.

$10,000 x 1.06 x 1.06 = $11,236


$10,000 x PVF (5%, 20 periods) 0.3769 = $3,769
$600 x PVF Annuity (5%, 20 periods) 12.4622 = $7,477
The profitability index of Project B $24,000 / $20,000 = 1.20, which is greater than the
profitability index of Project A at $55,000 / $50,000 = 1.10

50.

Pretax cost
Debt
10%
Common equity
15%
Weighted average cost of capital

51.
52.

Present value is $110,000 and $170,000, respectively


$20,000 x PVF Annuity (10%, 10 periods) 6.1446 = $122,892
$30,000 x PVF Annuity (10%, 10 periods) 6.1446 = $184,338
$20,000 x PVF Annuity (10%, 10 periods) 6.1446 = $122,892 - $110,000 = $12,892
$30,000 x PVF Annuity (10%, 10 periods) 6.1446 = $184,338 - $170,000 = $14,338
$122,892 / $110,000 = 1.117; $184,338 / $170,000 = 1.084
Payback is one year for Project A and two years for Project B
Because Project A receives more cash sooner, the net present value will be greater.
Investments 2 and 3 report positive net present values, which indicates the return is greater
than the required cost of capital
Investment 2 because it offers a 14% return over four years, and therefore, the profitability
index of 1.20 is the greatest.
$250,000 amount invested / $50,000 expected annual net cash inflow = 5.0 payback period
$30,000 average annual operating income from asset / [($250,000 + 0) / 2] average amount
invested in assets = 0.24 accounting rate of return
PV of annuity (10-year, 10%) $50,000 x 6.1446 = ...........$307,230
Investment.........................................................................(250,000)
Net present value..............................................................$ 57,230
$307,230 / #250,000 = 1.229
$250,000 investment / $50,000 expected annual net cash inflow = 5.0 PV annuity factor.
PV annuity factor for (10-year, 15%) = 5.0188, therefore IRR is approximately 15%.
$500,000 amount invested / $75,000 expected annual net cash inflow = 6.67 payback period
$20,000 average annual operating income from asset / [($500,000 + 0) / 2] average amount
invested in assets = 0.08 accounting rate of return
PV of annuity (10 years, 10%) $75,000 x 6.1446 = .........$460,845
Investment.........................................................................(500,000)
Net present value..............................................................$ (39,155)
$460,845 / $500,000 = 0.922
$500,000 investment / $75,000 expected annual net cash inflow = 6.67 PV annuity factor.
PV annuity factor for (10-year, 10%) = 6.1446 and PV annuity factor for (10-year, 5%) =
7.7217. Therefore, the IRR is between 5% and 10%.

53.
54.
56.
57.
58.
59.
60.
61.
62.
63.
64.
66.
67.
68.
69.
70.

AKY 4E Test Bank

After tax cost


(1-tax rate) 5%
15%

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Weight
60%
40%

Weighted average
3.0%
6.0%
9.0%

Schoenebeck

EXERCISE/PROBLEM
LO3
77. a.
b.

The present value is $7,000.


No, an investment of $7,000 will no longer result in $20,000 in 20 years. Due to the
lower interest rates, less interest will be earned over the 20 years, therefore, the initial
investment now needs to be greater than $7,000. PV + interest earned = FV.

LO3
78. Even though both annuities pay $500,000 in total, Annuity 1 is the better deal because the
total payback of $500,000 is received 10 years earlier.
LO3
79. a.
b.
c.

LO3
80. a1.
a2.
a3.
b.

No, the lottery winner is not receiving a $1,000,000 value because the entire sum is
not being received now. Because money can earn a return, its value depends on when
it is received.
Yes, this is an annuity because the winner is receiving the same amount at the end of
each year for 20 years.
The present value of the prize money is $623,110 = ($50,000 x 12.4622). This
indicates that the 20 payments of $50,000 each to be received in the future are only
worth $623,110 now, rather than $1,000,000.

Present value of the $25,000 at the end of ten years is $9,423 = $25,000 x 0.3769.
Present value of the $1,000 semiannual interest payments is $12,462 = $1,000 x
12.4622.
Present value of the $25,000 bond is $21,885 = ($9,423 + $12,462).
This bond is selling at a discount because the bond is only paying 8% ($2,000 per
year / $25,000 face) interest when the market rate is 10%. To achieve the higher yield,
the investor pays in less than face value (discounted), but at maturity the investor
receives the full $25,000 face value.

LO3
81. a.
Pretax cost
Debt
10%
Common equity
18%
Weighted average cost of capital
b.

After tax cost


(1-tax rate) 6%
18%

Weight
70%
30%

Weighted average
4.2%
5.4%
9.6%

Hitz Corporation may use the cost of capital as a benchmark for accepting or rejecting
capital investment proposals.

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LO4
82.
a.
b.
c.
d.
e.

Investment 1
PV of the initial investment
$210,000
PV of the annual cash flows
$227,448 = ($60,000 x 3.7908)
Net present value $17,448 = ($227,448 $210,000)
Profitability index 1.083 = ($227,448 / $210,000)

Investment 2
$135,000
$151,632 = ($40,000 x 3.7908)
$16,632 = ($151,632 $135,000)
1.123 = ($151,632 / $135,000)

The profitability index indicates that Investment 2 is preferred, while the net present
value method does not inherently distinguish between projects with different
magnitudes of initial investment. However, the final choice between these two
mutually exclusive alternatives may depend on qualitative factors that distinguish
between the two alternatives or identify other possible uses for the available funds.

LO4
83.
a.
Item
Amount
Purchase (820,000)
Services (40,000)
Salvage
600,000

Purchase the Jet


Yrs
PV@ 20%
now
(820,000)
1-5
(119,624)
5
241,140
(698,484)

Item
Rent

Amount
(250,000)

Rent the Jet


Yrs PV@ 20%
1-5 (747,650)

*Depreciation is not a cash flow.

b. Net present value indicates that purchasing the jet is the preferred alternative. However,
even though the net present values differ by $49,166, the additional risk of ownership may
sway the company to choose to rent on a use-by-use basis.
LO5
84. a.

The net present value is $45,691 when income taxes are taken into account.
Annual cash flow Depreciation Taxable income
$40,000
$13,000
$27,000
After-tax net cash flow
Initial investment
Annual cash flows
$29,200
Net present value

b.

Tax @ 40%
$10,800

Net cash flow


$29,200

PV factor of an annuity

Present value
($65,000)
110,691
($45,691)

3.7908 (5yrs, 10%)

Yes, Roberts should consider this purchase because the net present value is positive,
which indicates the purchase meets the companys 10% cost of capital requirement.

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LO4
85. a.

Project A payback period is 4 years.


Project B payback period is 2.33 years = (2 years + $10,000/$30,000)
The payback criterion indicates that Project B is the preferred investment because it
has the shorter payback period.

b.

The advantage of using the payback period criterion is that it gives an indication of the
projects risk, in the sense that the longer the payback period, the longer an
organization is exposed to an unrecovered investment. Drawbacks include that it
ignores the time value of money and that it ignores cash outflows after the initial
investment and cash inflows after the payback period.

c.

Project A accounting rate of return is 20% = (*$10,000 average income / **$50,000


average investment).
Average increase in income is [(10+20+30+40+50) / 5] = $30,000 per year
Depreciation is $100,000 / 5 years = $20,000 per year
* Average income is $10,000 = (Average increase $30,000 Depreciation $20,000)
** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]
Project B accounting rate of return is 20% = (*$10,000 average income / **$50,000
average investment).
Average increase in income is [(50+40+30+20+10) / 5] = $30,000 per year
Depreciation is $100,000 / 5 years = $20,000 per year
* Average income is $10,000 = (Average increase $30,000 Depreciation $20,000)
** Average investment is $50,000 = [($100,000 initial investment + 0 salvage value) / 2]
The accounting rate of return criterion indicates both projects are equally attractive.

d.

An advantage of the accounting rate of return is the incorporation of accounting


income rather than cash flows for all periods. Disadvantages include not considering
the time value of money and not explicitly considering the timing of cash flows.

e.

Project B is recommended because it has the shorter payback period.

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LO4
86. a.
----1---Present value of cash inflows
at a 10% discount rate
$56,727
Initial investment
(48,000)
Net present value
$ 8,727
b.

Profitability index
-------1------- -------2------1.18 = 56,727 1.20 = 43,340
48,000
36,000

----2---$43,340
(36,000)
$ 7,340

----3---$33,614
(27,000)
$ 6,614

-------3-----1.24 = 33,614
27,000

----4---$52,297
(45,000)
$ 7,297

-------4------1.16 = 52,297
45,000

----5---$37,976
(40,000)
$ (2,024)

-------5------0.95 = 37,976
40,000

c.

Only projects 1 through 4 are acceptable to Davidson Company. Project 5 is not


acceptable because the project does meet the cost of capital requirement of 10%. This
is pointed out with the negative net present value, the profitability index that is below
1, and the 8% internal rate of return.

d.

1.
2.
3.

e.

The profitability index indicates that Investment 3 is preferred, the internal rate of
return indicates that Investment 4 is preferred, while the net present value method
does not inherently distinguish between projects with different magnitudes of
investment. However, because the profitability index is considered superior to the
internal rate of return, I would recommend Investment 3. The final choice may depend
on qualitative factors that distinguish the four alternatives.

AKY 4E Test Bank

Net present value is unable to rank projects with different initial investments.
Profitability ranking from highest to lowest is
3 2 1 4 5
Internal rate of return ranking from highest to lowest is 4 3 1 2 5

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LO4
87. (Additional PV information is needed to complete this problem.)
a.
Payback period is 1.58 years =
$244,000 amount invested
.
$154,000 expected annual net cash inflow
b.

Accounting rate of return is 1.05 = $128,000 average annual operating income from asset
[($244,000 + 0) / 2] average amount invested in asset

c.

Present value of annuity of equal net cash inflows for ten years assuming a 16% required
rate of return $154,000 x 4.833 = .............$744,282
Investment.......................................................(244,000)
Net present value........................................$500,282

d.

$244,000 investment
= 1.58 annuity present value factor
$154,000 expected annual net cash inflow
A 1.58 annuity PV factor indicates an Internal rate of return of more than 50% for a tenyear investment.

e.

Yes, a Papa Johns company-owned restaurant appears to be a good investment because the
average payback period is less than two years, the average annual accounting rate of return
is over 100%, the investment more than delivers the 16% required rate of return, and the
internal rate of return is over 50%.

LO4
88. (Additional PV information is needed to complete this problem.)
a.
The total initial investment, over the two years, is $24,000,000. The after-tax cash
flows, as shown in the following exhibits are $4,100,000 per year. Therefore, the
payback period, after the two-year initial investment period, is 5.85 years
($24,000,000/$4,100,000).
b.

The initial investment is $24,000,000 and there is no salvage value. Therefore, the
average investment is $12,000,000 ($24,000,000/2). The machine has a 12-year life,
therefore the annual depreciation is $2,000,000. The annual taxes are $900,000 as
showing in the following exhibits. Thus, the annual after-tax accounting income is
$2,100,000 ($5,000,000 - $2,000,000 - $900,000). As a result, the accounting rate of
return is 17.5% ($2,100,000/$12,000,000).

c.

The net present value of this investment is ($252,737), as shown in the following
exhibits.

d.

The internal rate of return of this investment is approximately 11.8%, as shown in the
following exhibits.

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EXHIBIT 1
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13

EXHIBIT 2
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13

AKY 4E Test Bank

Investments
(14,000,000)
(10,000,000)

Taxes
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000
900,000

Operating
Cash Flows

Depreciation

Taxable
Income

5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000
5,000,000

2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000

3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000

Cash Flows
(14,000,000)
(10,000,000)
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000
4,100,000

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Present Value
@ 12%
(14,000,000)
(8,928,571)
3,268,495
2,918,299
2,605,624
2,326,450
2,077,188
1,854,632
1,655,921
1,478,501
1,320,090
1,178,652
1,052,368
939,614
(252,737)

Present Value
@ 11.8%
(14,000,000)
(8,944,544)
3,280,199
2,933,989
2,624,319
2,347,334
2,099,583
1,877,981
1,679,768
1,502,476
1,343,896
1,202,054
1,075,183
961,702
(16,059)

Schoenebeck

CRITICAL THINKING/ESSAY
LO1
89. Organizations use capital budgeting, a complex and time-consuming procedure, to evaluate
investments in long-term assets. Why do these assets deserve this attention?
Solution: Long-term assets commit the organization to a technology or a process for long
periods of time, creating a technological risk for the organization, and they can usually only
be reversed at great cost. The investment in long-term assets is usually the largest that an
organization makes, creating financial risk for the organization.
LO3
90. Some people believe that discounted cash flow analysis discriminates against long-term
projects because it heavily penalizes cash flows that occur well into the future. Comment.
Solution: Discounted cash flow analysis penalizes cash flows that occur into the future to
recognize the time value of money. For example, with a discount rate of 10%, a cash flow
received 10 years from now is discounted to about 39% of its future value. This is a big
penalty, however, it recognizes the time value of money and the real effect of investing in
long-term assets.
LO4
91. Why might a company use a 10% discount rate to evaluate capital project ABC, and a 15%
discount rate to evaluate capital project XYZ?
Solution: The discount rate is adjusted for the level of risk involved with the project. The
higher the discount rate used, the higher the level of risk for the project.
LO4
92. Explain the profitability index and the payback methods used in capital budgeting. Discuss
when it would be most appropriate to use each.
Solution: The profitability index compares the present value of all future cash inflows with
the present value of all future cash outflows. The discount rate allows for various amounts
of risk. This is the most comprehensive capital budgeting analysis tool and it is used to
evaluate the acceptability of a project and to rank projects.
The payback method uses the time to recover the initial investment as a measure of risk. It is
easy to use but because this method does not utilize the time value of money, its use is
usually limited to screening out unacceptable projects.
LO4
93. List two capital budgeting methods that utilize the time value of money and explain how
each ranks the performance of different alternatives.
Solution: Two capital budgeting methods that utilize the time value of money are the net
present value (NPV) method and the internal rate of return (IRR) method. The profitability
index is used to rank the performance of capital projects evaluated using the NPV method.
The IRR percentages can be used to rank the performance.

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LO4
94. Explain how the internal rate of return criterion, if improperly applied, can cause managers
to make inappropriate investment decisions.
Solution: Suppose that an organization's cost of capital is 12% and that a decision maker has
been told that she will be rewarded based on the return on investment of the assets under her
control. The manager will be motivated to make return on investment as high as possible.
Therefore, investments that provide a return on investment that is lower than the current
average will be rejected, even though they may exceed the organization's cost of capital. The
problem with return on investment is that it is improperly used for motivational purposes.
LO6
95. You are considering an investment in a new restaurant chain. You have developed estimates
of the initial investment required and the cash flows from that investment. However, you are
wondering about the risk of your investment. How might you assess the impact of estimates
in your investment decision?
Solution: One approach is to use sensitivity analysis. In this approach, the investor would
vary the cash flow estimates to identify how sensitive the decision to invest is to the
estimated cash flows. If the decision is very sensitive, that is, a 5-10% decrease in cash
flows would shift the investment decision from positive to negative, then the investor might
want to take steps to improve the reliability of the forecasts or not invest in the project.
LO7
96. An organization is considering investing in an employee-training program. The
organization's planners expect that this training program, which would cost $5,000,000, will
reduce manufacturing costs and increase the quality of the company's various products.
How would you frame this decision in the capital budgeting context?
Solution: If this project is to be evaluated using a capital budgeting tool, the organization
will have to quantify the expected benefits of the training program. This may be difficult to
do and, because of this, many organizations make investments like this as an act of faith that
the benefits will exceed the costs.
LO8
97. An organization's planners have received a proposal from a manufacturing group to invest in
a new production line. The planners are suspicious that the proposal reflects the group's
interest in acquiring the latest technology rather than reflecting sound economic evaluation.
How might the planners deal with this situation?
Solution: A common tool is to inform people proposing capital investments that the
organization will perform post-implementation audits on all investment projects to identify
whether benefits were as claimed and, if not, why not. Because this imposes risk on the
people who propose projects, post-implementation audits dampen enthusiasm for all project
proposals, not simply those that reflect non-economic considerations. Therefore, the
organization must make it clear that the post-implementation audits will try to ensure that
the audits are undertaken fairly with due consideration of events that would have been
unforeseeable when the project was proposed.

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LO8
98. Officials at Dundas Manufacturing have just completed a post-implementation audit of a
distribution center that was built 2 years ago at a cost of $15,000,000. The marketing group
had proposed the warehouse investment arguing that it would improve sales by increasing
product quality and improving customer service. The expected rate of return on this
investment was 18%, however, the actual return on this investment to date has fallen far
below this estimate and it is even below the company's cost of capital of 11%. The postimplementation audit concluded that the managers proposing this investment were
ambitious, to the point of being reckless, in making the estimates underlying the project's
proposals and argued that the investment should never have been made.
In response, the two managers who proposed the project argue that the proposal was a
good one based on estimates that seemed sound at the time. However, several
uncontrollable events, including the entry of a new competitor into the market, caused
results to be lower than expected. Moreover, the two managers argue that results would
have been even worse for the company if the investment had not been made. How would
you deal with this situation?
Solution: This situation reflects the critical issue in interpreting a situation where events
were not as expected. The argument hinges on two things. First, it is unreasonable to expect
managers to be responsible for things beyond their control -- what is often called the
controllability principle in management accounting. Second, the events that occurred in this
situation were beyond the managers' control.
Many people believe that the controllability principle is fundamental because it appeals to a
common sense of fairness, namely that people should only be held accountable for what they
do or control. However, some people have argued that making people accountable for
whatever happens motivates them to search for ways to gain control over their environment.
Therefore, while rejecting the controllability principle at first seems harsh and conflicting
with a common view of equity, there may be good behavioral reasons for doing this.
However, for the sake of discussion here, let us assume that the controllability principle is
applied. There are two issues in this case: first, whether or not these managers should
reasonably have anticipated the arrival of the new competitors and second, what would the
results of the new competitor have been if the organization had not built the new warehouse.
These issues are problematic and would have to be resolved by reference to the facts in the
particular situation including what other competitors were doing, public announcements by
the competitor, and what analysts who were following this market were writing and saying.

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