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All changes to chapter 27 were minor.

Approach

Capital investment decisions are a special kind of alternative choice problem. They are analyzed in the

same way as that used for the problems described in Chapter 26, with the exception that the timing of

cash inflows and outflows must be taken into account. This one difference is an important one, however.

In order to incorporate its effect in the analysis, one must have a thorough understanding of the concept of

present value. Because of the difficulty that students seem to have with the topic, the discussion of present

value in the first part of this chapter proceeds quite slowly unless the Appendix to Chapter 8 was

previously assigned and discussed. Once students understand the nature and use of this concept, they

should have relatively little difficulty with most other topics discussed in the chapter.

Quite early in the chapter, the steps in analyzing a capital investment problem are set forth. As various

aspects of the analysis are discussed, it is a good idea to relate each of them to these steps, and to keep the

students continually aware of the purpose of the analysis, namely, to reach a decision on the acceptability

of a proposed capital investment.

The reason for the omission of depreciation is often difficult to understand. Students must appreciate that

the procedure takes into account the recovery of the investment, and that to include depreciation as a

separate item of cost would be double counting. In addition to the text discussion of this point, it may be

desirable to introduce additional illustrations. It may also be desirable to relate this topic to the

corresponding discussion in Chapter 26.

Students have difficulty in understanding the depreciation tax shield. They learned in Chapter 26 that

noncash costs are to be disregarded, but now they are told that noncash depreciation is to be counted, and

this seems contradictory. This point needs to be discussed in depth. Students should understand that the

amount of depreciation does not directly enter the cash flow calculation. It is the amount of income tax

that is the cash flow; depreciation is used only to calculate the amount of income tax. The description and

the examples have been stated and arranged in such a way that, hopefully, this point is emphasized.

In the latter part of the chapter, several methods of investment analysis are described and compared.

Although the net present-value method is described as being superior to the discounted cash-flow method,

not too much importance should be attached to this point. In most real-life problems, either method gives

satisfactory results. Any method that uses present values is superior to all methods that disregard present

values (e.g., payback, unadjusted return), and it is a good idea to stress this point. (In practice, companies

tend to use several methods simultaneously.)

Cases

Sinclair Company is a carefully sequenced set of assumptions about one proposed equipment acquisition,

each of which makes a separate point.

Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects asks students to build cash flow

forecasts and then to rank mutually exclusive projects using various evaluation criteria.

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Problems

Problem 27-1

Land Donated Land Sold

Calculation of Net Income:

Pretax income before disposal......................................................................................................................................................

$10,000,000 $10,000,000

Addition to (deduction from) taxable income...............................................................................................................................

(110,000) 110,000

Pretax income after disposal.........................................................................................................................................................

9,890,000 10,110,000

Income tax @ .40.........................................................................................................................................................................

$ 3,956,000 $ 4,044,000

10,000,000 10,000,000

Less book value of land................................................................................................................................................................

10,000

Plus gain on sale of land...............................................................................................................................................................

_ 100,000

Pretax accounting income.............................................................................................................................................................

9,990,000 10,100,000

Less income tax (above)...............................................................................................................................................................

3,956,000 4,044,000

Net Income...................................................................................................................................................................................

$ 6,034,000 $ 6,056,000

Saving in tax .40 x $110,000.......................................................................................................................................................

$ 44,000

Cash from sale..............................................................................................................................................................................

$ 110,000

Less additional tax........................................................................................................................................................................

_ 88,000

Additional cash.............................................................................................................................................................................

$ 44,000 $ 22,000

Strangely enough, the company is better off to donate the land rather than to sell it.

Notes:

(1) It would also be correct to calculate the additional tax at a capital gains rate of, say, 25 percent.

(2) The cost of the land is disregarded in the tax calculation. Actually, the taxable gain would probably be

$110,000 - $10,000 = $100,000.

(3)

Problem 27-2: Plastic Recycling Company

a. Comparisons of Cash Flows and Taxable Income:

Year

1 2 3 4 5 Total

Straight-line (a)........................................................................................................................................................................

$6,000 $6,000 $6,000 $6,000 $6,000 $30,000

MACRS...................................................................................................................................................................................

6,000 9,600 5,400 4,500 4,500 30,000

Difference in taxable income....................................................................................................................................................

0 - 3,600 + 600 +1,500 +1,500 0

Difference in tax @ .40............................................................................................................................................................

0 - 1,440 + 240 + 600 + 600 0

Difference in after-tax income..................................................................................................................................................

0 - 2,160 + 360 + 900 + 900 0

Difference in cumulative cash

flow (tax postponed)............................................................................................................................................................

0 1,440 1,200 600 0

b. The MACRS method produces faster cash flows because of the tax advantage in early years which

decreases the funds spent for taxes.

(2) $30,000 x MACRS allowance for given year.

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2007 McGraw-Hill/Irwin Chapter 27

a. SELL OR RENT

If sell

Cost..............................................................................................................................................................................

$270,000

Accumulated depreciation............................................................................................................................................

180,000 ($270,000/15 years) x 10 years

Book value...................................................................................................................................................................

90,000

Selling price.................................................................................................................................................................

225,000

Long-term gain.............................................................................................................................................................

135,000

Tax @ .30.....................................................................................................................................................................

40,500

Net gain after tax..........................................................................................................................................................

94,500

Net cash inflow = $225,000 - $40,500.........................................................................................................................

$184,500

If rent

Rent proceeds per year................................................................................................................................................

$72,000

Maintenance, etc..........................................................................................................................................................

$27,000

Depreciation................................................................................................................................................................

18,000 45,000

Net rent income before tax..........................................................................................................................................

27,000

Tax @ .40....................................................................................................................................................................

10,800

Net rent after tax..........................................................................................................................................................

$16,200

b. The cash flow of $45,000 - $10,800, or $34,200, after tax for five years is $171,000, which is less

than the after-tax profit from a sale now.

(The present value of $34,200 for 5 years at, say, 10%, is $129,652, even less than the $171,000 and

more accurate, making the sale even more attractive.) But, the value of the warehouse 5 years hence

is not mentioned. It might be sold at a large enough gain to offset the difference between rent

proceeds and a sale now. Rent might increase, or expenses increase. Evidence is weighted in favor of

a sale now for after-tax benefits.

Problem 27-4

a. The investment/inflow ratio = $10,000 annual cash inflow = 6.2, so if the investment is $10,000, the

annual cash inflow is $10,000 6.2, or $1,613.

c. An investment/inflow ratio of 6.2, for 12 years, from Table B is approximately a 12% internal rate of

return.

b. The investment/inflow ratio = investment $2,000 = 6.14, so the investment = $12,280 ($2,000 x

6.14).

c. The investment/inflow ratio from Table B for 7 years, at 16% is 4.039. The investment is therefore

$5,000 annual cash inflow x 4.039 = $20,195, the maximum price to pay.

d. The investment/inflow ratio for 8 years, at 14%, from Table B, is $4,639, which is the maximum

investment per dollar of annual savings.

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Calculation of Project Returns

Investment/

Project Useful Life Inflow (a) Return (b) Rank

1 6 years 4.0 13% 1st

2 4 3.3 8% 3rd

3 15 8.0 9% 2nd

4 2 2.0 0% 4th

5 3 4.0 negative 5th

(a) $100,000 $25,000 = 4.0

100,000 30,000 = 3.3

40,000 5,000 = 8.0

20,000 10,000 = 2.0

50.000 12,500 = 4.0

(b) Returns for Projects 1-3 are from Table B. Project 4s return is zero, since the nondiscounted

inflows ($10,000 x 2) exactly equal the initial investment. Project 5 over its entire life returns

only $37,500 of the initial $50,000 investment, so its return must be negative.

Problem 27-6: Baxton Company

a. Differential after-tax cash flows (000 omitted):

Sales..............................................................................................................................................................................................

$1,000 $1,600 $800

Material, labor, direct overhead.....................................................................................................................................................

400 750 350

Added rent (12,500 x $4)..............................................................................................................................................................

50 50 50

Depreciation..................................................................................................................................................................................

450 300 150

Differential cost.............................................................................................................................................................................

900 1,100 550

Differential income.......................................................................................................................................................................

100 500 250

Differential income taxes (40%)....................................................................................................................................................

40 200 100

Differential net income..................................................................................................................................................................

60 300 150

Add back depreciation...................................................................................................................................................................

450 300 150

Differential cash flow from product..............................................................................................................................................

510 600 300

Salvage value................................................................................................................................................................................

-- -- 180

Net differential cash flow..............................................................................................................................................................

$ 510 $ 600 $480

Cash outlay for project:

Purchase price..............................................................................................................................

$ 900

Modifications...............................................................................................................................

30

Installation...................................................................................................................................

60

Testing.........................................................................................................................................

90

Total.............................................................................................................................................

$1,080

Less: Salvage 180

Depreciable Base $ 900

b. The payback period is slightly less than two years, since the initial investment is $1,080,000 and the

sum of the first two years inflows is $1,110,000. Thus, if a two-year payback period is the decision

criterion, the project is acceptable.

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2007 McGraw-Hill/Irwin Chapter 27

$ 13,500

1991 Net income............................................................................................................................

232,500

1992 Net income............................................................................................................................

106,500

$352,500

Average income.............................................................................................................................

117,500 (1)

Average investment*......................................................................................................................

540,000 (2)

Accounting rate of return...............................................................................................................

22% (12)

Average Investment

Net Depreciation 900 (.6) = $ 540

Cash outlay for equipment = 1,080

$1,620/3 = $ 540

1990: $510,000 x 0.833 = $ 424,830

1991: 600,000 x 0.694 = 416,400

1992: 480,000 x 0.579 = 277,920

$1,119,150

The present value of $1,119,150 is greater than the initial outlay of $1,080,000; therefore, the project

more than satisfies the 20% requirement.

e. If the student does not have access to a calculator or computer programmed to make IRR calculations,

the IRR must be estimated using a trial-and-error approach. The IRR is slightly in excess of 22%, as

shown by these calculations:

Year Cash Flow 22% Factor 22% P.V. 24% Factor 24% P.V.

1990: $510,000 0.820 $ 418,200 0.806 $ 411,060

1991: 600,000 0.672 403,200 0.650 390,000

1992: 480,000 0.551 264,480 0.524 251,520

$1,085,880 $1,052,580

*The initial investment ($1,080,000) is sometimes used in this calculation; this would make the accounting rate of return =

11%.

Cases

Note on Use of Cases

The same general line of attack can be used for several of the cases: (1) make a quantitative calculation;

(2) consider the nonquantitative factors; and (3) reach a decision. Ideally, we think half the time should be

spent on the first point and half the time on the last two, but it never seems to work out that way. Instead,

the problem is to get through the figures rapidly enough so that one has any time left to discuss the

nonquantitative matters and the decision. In order to do this, we often cut off the discussion of specific

problems in the figures by some such device as taking a vote, using the figure of the person who seems to

be making the best argument, or even using our own figure. This must be done carefully and with

appropriate cautions to the effect that we are not passing over the figures lightly, but simply that we are

not taking the time to consider all the aspects of the figures so that we can have some time to discuss the

action.

It is unfortunate if the decision part of the problem is omitted. If this is done. students may get the

impression that the decision is of little importance, whereas actually, of course, it is crucial.

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

There are several valid ways in which the figures may be put together. There are also several ways of

arriving at the basic figures for investment and earnings. This may lead to confusion when students come

to class with solutions prepared in accordance with different methods. One way of avoiding this is to

specify a method when assigning the case. We prefer to let the students use whatever method they wish,

and expect them to be able to follow someone elses method as it unfolds in class. Often, after someone

has started the class discussion with a valid method, we ask everyone to continue to develop the data in

accordance with that method, and although they do not like to make the adaptation, they usually can do it.

The commentaries to several of the cases are more detailed than students reasonably can be expected to

develop in class.

Case 27-1: Sinclair Company

Note: This case is unchanged from the Eleventh Edition.

Approach

These problems are constructed so that each one builds on the preceding one and brings out a new point.

It often happens that in connection with the very first problem, students raise questions that range all over

the chapter. I ask them not to do this, as the questions usually can be handled better later on in connection

with the specific problems to which they apply.

Also, I prefer to get right to the problems, rather than spending very much time on the text. I do go over

the idea of present value and answer some questions, but I think troublesome points are best handled in

the context of specific problems.

In introducing Part A, I may ask: If you were going to buy a machine and had your choice of paying $5

now, or $1 a year for the next five years, which would you take? Next If you had your choice of paying

$5 now or $1 per year for six years? For seven years? This seems to help in clearing up the idea of

contrasting the one-shot cost with the stream of earnings and the notion of the present value of a stream of

payments.

Comments on Questions

PART A

1. Investment.............................................................................................................................................................................

$250,000

Annual savings......................................................................................................................................................................

72,000

Present value of $1 a year, 5 years, 15 percent......................................................................................................................

3.352

Total present value of savings...............................................................................................................................................

241,344

Decision: Net present value = -$8,656; therefore..................................................................................................................

Do not purchase

2. Same as question 1.

Moral: Book value makes no difference. The figures and decision are the same as in 1. Nevertheless, a

profit center manager may not view the $135,000 write-off as irrelevant, even though it does represent a

sunk cost.

3. Investment, gross..................................................................................................................................................................

$250,000

Less salvage on old...........................................................................................................................................................

75,000

Net investment...............................................................................................................................................................

175,000

Annual earnings....................................................................................................................................................................

72,000

Present value: $72,000 * 3.352.............................................................................................................................................

241,344

Decision: Net present value = $66,344; therefore.................................................................................................................

Purchase

Moral: The resale value of the superseded machine reduces the amount of new funds required which (in

this case) changed the decision.

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2007 McGraw-Hill/Irwin Chapter 27

4. Investment................................................................................................................................................................

$250,000

Annual earnings.......................................................................................................................................................

37,500

Present value, 10 years, 15%: $37,500 * 5.019........................................................................................................

188,213

Decision: Net present value = -$61,787; therefore...................................................................................................

Do not purchase

Moral: Although total earnings are approximately the same as in question 1 ($375,000 versus $360,000),

the present value is considerably different. It is the pattern of earnings through time that counts, not the

total amount.

PART B

1. Investment................................................................................................................................................................

$500,000

Annual earnings.......................................................................................................................................................

160,000

Present value: $160,000 * 3.352..............................................................................................................................

536,320

Decision: Net present value = $36,320; therefore....................................................................................................

Purchase

(If Model A has resale value, the return would be even higher.)

2. The error arose when Model A was purchased. Assuming the situation in A(3), Model A has an

acceptable return if its economic life is 5 years. It turns out that its economic life was only two years;

consequently, Model A should not have been bought (although this is known only from hindsight).

Moral: Dont let past mistakes prevent you from making wise decisions now (i.e., sunk costs are

irrelevant).

PART C

The 1981 Tax Act (and subsequent acts) with ACRS provisions usually makes this kind of a

computational nightmare for students, because of the erratic depreciation (officially, cost recovery)

amounts in years 1-5, and the absence of such amounts in later years.

We have assumed that the ACRS allowances stay at 35%, 26%, 15%, 12%, 12% for 5-year assets. The

cash flow pattern, including a 5% (assumed to be time zero) ITC, is:

$383,328

Add: PV of ACRS depreciation tax shield for $500,000 machine = $417,970 * .40................................................

167,188

550,516

Deduct: PV of depreciation shield from old machine sacrificed

($50,000/yr. for 3 more years) = $50,000 * .40 * 2.577 (Table B)............................................................................

51,540

Net present value of earnings...................................................................................................................................

$498,976

Since $498,976 is more than the net investment of $433,000, the decision is to purchase.

$417,970

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

PART D

1. Investment..............................................................................................................................................................................

$250,000

Present value of earnings

Years 1-3: $79,500 * 2.283 (Table B)...............................................................................................................................

$181,499

Years 4-5: $60,750 * 1.069*.............................................................................................................................................

64,942

Total PV of earnings.....................................................................................................................................................

$246,441

2. Although the total earnings for the 5-year period are the same in Part D as in A(1), shifting more

of the earnings to the early years and less to the later years increases the present value from

$241,344 to $246,441.

$237,500

Present value of cash savings:

Years 1-3: $79,500 * .60 (1 - tax rate) * 2.577.................................................................................................................

$122,923

Years 4-5: $60,750 * .60 * l.416......................................................................................................................................

51,613

Present value of ACRS depredation tax shield:

$208,985 * .40..................................................................................................................................................................

83,594

Total present value.................................................................................................................................................................

$258,130

*3.993 (5 yrs.) 2.577 (3 yrs.)

Moral: The combination of tax-shield benefits and a shift in earnings now makes the decision to purchase

a good one (even without the $12,500 ITC).

Note: This case is unchanged from the Eleventh Edition.

Approach

Whereas many capital budgeting problems deal with comparative evaluation of alternative asset

acquisitions, this case involves analyzing two ways of financing a given asset acquisition. Since lease-

versus-buy is a common alternative choice problem in both business and nonbusiness organizations, this

case provides relevant experience for students. The class session can deal sequentially with the assigned

questions. Question 3 is the most difficult and subject to students omissions and differing assumptions.

Question 4 is interesting, but not crucial should class time become scarce.

EXHIBIT A

Purchase Lease

Year Transaction Inflow Outflow Outflow Inflow

0 *Disposal of old carts.......................................................................................................................................................

8,000 8,000

0 *Tax effect of disposal1.....................................................................................................................................................

2,720 2,720

0 Purchase cost....................................................................................................................................................................

89,600 n.a.

1-5 *Cart revenues2.................................................................................................................................................................

55,440 55,440

1-5 *Cart expenses3.................................................................................................................................................................

11,088/yr. 11,088/yr.

1-5 Lease payments4...............................................................................................................................................................

n.a. 13,200/yr

1 Depreciation tax shields5...................................................................................................................................................

9,520 n.a.

*

This teaching note was prepared by Professor James S. Reece. Copyright by James S. Reece.

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2007 McGraw-Hill/Irwin Chapter 27

7,072 n.a.

3 Depreciation tax shield........................................................................................................................................

4,243 n.a.

4 Depreciation tax shield........................................................................................................................................

3,182 n.a.

5 Depreciation tax shield........................................................................................................................................

3,182 n.a.

5 Proceeds from disposal........................................................................................................................................

9,600 n.a.

0 Time Zero flow....................................................................................................................................................

84,320 5,280

1-5 NPV of net streams..............................................................................................................................................

44,352* 31,152*

3.993 = 177,098 3.993= 124,390

Factor

1 NPV.....................................................................................................................................................................

0.926 8,816 n.a.

2 Of.........................................................................................................................................................................

0.857 6,061 n.a.

3 Depreciation.........................................................................................................................................................

0.794 3,369 n.a.

4 Tax.......................................................................................................................................................................

0.735 2,339 n.a.

5 Shield...................................................................................................................................................................

0.681 2,167 n.a.

5 NPV of disposal proceeds....................................................................................................................................

0.681 6,538 n.a.

NPV of Each Alternative....................................................................................................................................................

$122,068 $129,670

NPV Using 5.28% Discount Rate.......................................................................................................................................

$137,755 $139,114

NOTES TO EXHIBIT A:

*Items so marked can be eliminated from the analysis because they are the same for either alternative,

and because not, acquiring the new carts has been excluded by the case as an alternative.

2. $84,000 * (1 - .34)

1 $28,000 $9,520

2 20,800 7,072

3 12,480 4,243

4 9,360 3,182

5 9,360 3,182

$80,000 = $89,600 - $9,600 residual value

Case 27-3: Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects*

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Synopsis

Phuket Beach Hotel has an opportunity to lease its under-utilised space to a karaoke pub and earn a rental income.

Alternatively, the hotel could develop the unused space and create its own pub. The general manager of the hotel

must decide which of the two capital projects to recommend to the hotel owners. The case presents sufficient

information to build cashflow forecasts for each project and to rank the mutually exclusive projects using various

evaluation criteria.

Teaching Objectives

This case may be used to expose students to a range of capital-budgeting issues:

The principle of incremental analysis for identifying relevant cashflows for a project.

The treatment of sunk costs, corporate overhead allocations, opportunity costs, externalities and social costs

in the identification of relevant cashflows.

The use of DCF versus non-DCF techniques in evaluating capital budgeting projects.

The use of the equivalent-annuity criterion to solve the problem in ranking projects of unequal life.

Suggested Questions

1. Please assess the economic benefits associated with each of the capital projects. What is the initial outlay?

What are the incremental cashflows over the life of the project? What is an appropriate discount rate to use

for discounting the cashflows of the projects?

2. Rank the projects using various measures of investment attractiveness. Do all the measures rank the

projects identically? Why or why not? Which criterion is the best?

3. Are the projects comparable based on the standard NPV measure, given that they have unequal lives? What

adjustment or alternative method is required in comparing such projects?

4. How sensitive is your ranking to changes in the discount rate? What other key value drivers would affect

the attractiveness of the projects? Please estimate the sensitivity of your result to a change in any of the key

value drivers.

5. Which project should the hotel undertake?

Analysis

Identify the relevant cashflows and incremental cashflows

In evaluating the projects in this case, we should focus on those cashflows that occur if and only if we accept the

projects. These cashflows, called incremental cashflows, represent the changes in the firms total cashflow that

*Mary Ho prepared this Teaching Note under the supervision of Prof. Su Han Chan and Prof. Ko Wang as a guideline to

teaching: Phuket Beach Hotel: Valuing Mutually Exclusive Capital Projects. 2001 by The Asia Case Research Centre, The

University of Hong Kong.

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2007 McGraw-Hill/Irwin Chapter 27

occurs as a direct result of accepting the projects. They include changes in existing revenues, expenses and taxes

caused by a projects acceptance. The financial controller in this case stresses the importance of identifying future

profits instead of cashflows. Students should note that accounting profits are not the relevant measure of benefits.

Ignore sunk cost

A sunk cost is an outlay that has already been committed or that has already occurred, hence is not affected by the

decision under consideration. In this case, the overhead expenses and salary expenses of the excess labour can be

considered as sunk costs. Note that repairs and maintenance expenses will increase if the karaoke projects are

accepted. In this situation, it is appropriate to include such incremental expenses in the cashflow estimates for both

projects.

Consider externalities

Externalities represent the effects of a project on other parts of the firm. In this case, the possible reduction in room

sales should be considered in the analysis for both projects. The social effects of the projects are difficult to quantify;

yet they should be taken into account if the detrimental effect on the hotel will affect the projects future cashflows.

Consider opportunity costs

Opportunity costs are cashflows that could be generated from an asset the firm already owns, provided it is not used

for the project in question. Because the two projects in this case are mutually exclusive, the opportunity costs of one

project are the cashflows that are forgone due to the rejection of the other project.

Project Evaluation Techniques

In this case, since it is technically impossible for the hotel to undertake both projects on the same site, the

acceptance of one project implies the rejection of the other. Thus the two projects are mutually exclusive and a

ranking of the two projects in terms of their economic attractiveness becomes necessary.

The present capital budgeting system in Phuket Beach Hotel ranks projects according to payback period and average

return on investment. Although these methods are simple to use, they have a number of weaknesses that disqualify

them as effective methods for ranking projects. In fact, there are other project evaluation techniques that are more

effective.

The following table summarises the advantages and disadvantages of each of the project evaluation techniques.

I. Non-discounted Cashflow Techniques

Advantages Disadvantages

Can be used as a rough screening tool Ignores cashflows beyond the payback period

riskiness and liquidity period is arbitrary

(=Average annual cashflow after taxes/ Net investment)

Advantages Disadvantages

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Note:

The discounted payback method is similar to the regular payback method except that it discounts cashflows at the

projects cost of capital. It considers the time value of money but it ignores cashflows occurring after the payback

period.

II. Discounted Cashflow Techniques

Advantages Disadvantages

Takes into account the time value of money Possible existence of multiple IRRs

Is, in general, consistent with the firm goal of Requires more complicated calculations

shareholder wealth maximisation

incremental costs and benefits

cashflows from the project are reinvested at the

IRR, rather than at the opportunity cost of

capital

(d) Profitability Index (PI)

Advantages Disadvantages

Is consistent with the firm goal of shareholder Requires detailed long-term forecast of

wealth maximisation incremental costs and benefits

the scale of investment

(e) Net Present Value (NPV)

Advantages Disadvantages

Is consistent with the firm goal of shareholder Requires detailed long-term forecast of

wealth maximisation incremental costs and benefits

The information required for estimating the weighted average cost of capital (WACC) for Phuket Beach Hotel is

provided in the case on page 3.

Kc = w1Kd (1 t) + w2Ke

w1 = proportion of total financing that is debt

w2 = proportion of total financing that is common equity

t = tax rate

Kc = 0.25 0.1 (1 30%) + 0.75 0.12

= 10.75%

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2007 McGraw-Hill/Irwin Chapter 27

Summary of Results

For detailed computations and assumptions, please refer to Exhibits TN-1 and 2.

Lease Option Planet Karaoke Pub Build Option Beach Karaoke Pub

Discounted payback 3.01 years 4.95 years

Average return on investment 39% 30%

IRR 21% 17%

PI 1.21 1.22

NPV 165,017 baht 373,043 baht

The above summary shows that ranking conflicts have arisen. The first four measures favour the lease option while

the PI and NPV measures favour the build option. The last measure, equivalent annuity, which solves the unequal

life problem, also favours the build option. (Please refer to the earlier exhibit on the pros and cons of using each

measure.)

The graph below illustrates the classic cross-over problem, in which conflict in project rankings arises on the basis

of the NPV and IRR criteria. The standard approach to this problem is to rely on the ranking by NPV, because the

implicit reinvestment-rate assumption in the NPV method is more reasonable than that in the IRR method.

NPV Profiles of the Lease and Build Option

The graph shows that the NPV profiles of the two projects cross over when the discount rate used is 16%. The

ranking conflict between NPV and IRR disappears at discount rates above 16%. Note that the build options net

present value profile has the steeper slope, indicating that a given change in discount rate has a larger effect on its

net present value. The build option has a greater sensitivity because it offers rising cashflows in the later years. Its

cashflows in the later years have a relatively smaller present value at higher discount rates.

Sensitivity Analysis

Small changes in key variables might affect the economic attractiveness of the proposed projects. Students should

therefore test the sensitivity of the ranking to changes in key value drivers.

Some of the key value drivers in this case are listed below:-

Patronage factor

Cost of capital

Sensitivity Analysis: patronage factor

Patronage factor [see Exhibits Lease Option EA Build Option EA (baht) Decision

TN-1 & 2] (baht)

0.25 658,428 709,990 Build

1

The equivalent annuity approach compares projects with unequal lives. See note 2 in Exhibit TN-1 for detailed computations.

13

Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

0.75 (552,616) (534,901) Reject both

1 (1,158,138) (1,157,347) Reject both

investment (baht)

0% (base) 52,906 87,545 Build

5% 43,450 57,680 Build

10% 33,994 27,816 Lease

20% 15,082 (31,912) Lease

30% (3,830) (91,641) Reject both

(baht)

8% 66,676 122,557 Build

10.75% (base) 52,906 87,545 Build

12% 46,536 71,332 Build

14% 36,207 45,022 Build

16% 25,712 18,274 Lease

18% 15,057 (8,889) Lease

20% 4,247 (36,449) Lease

22% (6,712) (64,385) Reject both

Equivalent Annuity (in baht) Sensitivity Analysis: cost of capital & patronage factor

The Build Option

Cost of capital

Factor

14

2007 McGraw-Hill/Irwin Chapter 27

Cost of capital

Factor

[Build - Lease]

Cost of capital

Factor

EXHIBIT TN-1

THE LEASE OPTION: PLANET KARAOKE PUB ANALYSIS OF OPERATING CASHFLOW

Renovation cost 770,000 baht

Tax rate 30%

Cost of capital 10.75%

Increase in repairs & maintenance 10,000 baht

Patronage factor 0.5

0 0%

0.25 6.25%

0.5 12.50%

0.75 18.75%

1 25%

15

Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

Year 0 1 2 3 4

Net room revenue* 13,200,000 13,464,000 14,137,000 14,844,000

Reduction in net room

revenue 1,650,000 1,683,000 1,767,125 1,855,500

Year 0 1 2 3 4

Rental income 2,040,000 2,040,000 2,142,000 2,142,000

Less: Depreciation expense (192,500) (192,500) (192,500) (192,500)

Increase in repairs

& maintenance (10,000) (10,000) (10,000) (10,000)

Reduction in net

room revenue (1,650,000) (1,683,000) (1,767,125) (1,855,500)

Additional operating

income 187,500 154,500 172,375 84,000

Less: taxes (56,250) (46,350) (51,713) (25,200)

Add: Depreciation 192,500 192,500 192,500 192,500

Less: Capital expenditure (770,000)

Operating cashflow (770,000) 323,750 300,650 313,163 251,300

Discounted operating

cashflow (770,000) 292,325 245,117 230,536 167,039

Notes: 1. Average return on investment is calculated as the average of the cashflows over the life of the project

divided by the upfront investment.

2. The equivalent annuity is that level annual payment over the life of the investment that yields a present value just

equal to the net present value of the entire cashflow stream. The annuity is determined by solving for A: A =

NPV/PVIFA n.k, where PVIFA =[(1 + k)n 1]/k n = number of periods k = discount rate

Discounted payback 3.01 Years

Average return on investment 39%

IRR 21%

Profitability Index 1.21

NPV 165,017 Baht

EA 52,906 Baht

16

2007 McGraw-Hill/Irwin Chapter 27

EXHIBIT TN-2

THE BUILD OPTION: BEACH KARAOKE PUB ANALYSIS OF OPERATING CASHFLOW

Upfront investment

- renovation 800,000 baht

- equipment 900,000 baht

Tax rate 30%

cost of capital 10.75%

Sales growth rate 5%

Food and beverage cost 25% of sales

Salary 16% of sales

Other operating expense 22% of sales

Increase in repairs and maintenance 10,000 baht

Annual capital expenditure equals depreciation

Patronage factor 0.5

Patronage factor Decrease in net room revenue

0 0%

0.25 6.25%

0.5 12.50%

0.75 18.75%

1 25%

17

(Figures in baht except where otherwise stated)

Year 0 1 2 3 4 5 6

Net room

revenue 13,200,000 13,464,000 14,137,000 14,844,000 15,140,000 15,443,000

Reduction in

net room

revenue 1,650,000 1,683,000 1,767,125 1,855,500 1,892,500 1,930,375

Year 0 1 2 3 4 5 6

Sales 4,672,000 4,905,600 5,150,880 5,408,424 5,678,845 5,962,787

Less: Food and

beverage cost (1,168,000) (1,226,400) (1,287,720) (1,352,106) (1,419,711) (1,490,697)

Other operating

expenses (1,027,840) (1,079,232) (1,133,194) (1,189,853) (1,249,346) (1,311,813)

Increase in

repairs and

maintenance (10,000) (10,000) (10,000) (10,000) (10,000) (10,000)

Depreciation (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)

Reduction in

net room

revenue (1,650,000) (1,683,000) (1,767,125) (1,855,500) (1,892,500) (1,930,375)

Additional

operating

income 532,827 623,635 669,508 717,631 823,955 936,569

Less: taxes (159,848) (187,090) (200,852) (215,289) (247,186) (280,971)

Add:

Depreciation 283,333 283,333 283,333 283,333 283,333 283,333

Less: Capital

expenditure (283,333) (283,333) (283,333) (283,333) (283,333) (283,333)

Upfront

investment (1,700,000) - - - - - -

Operating

cashflow (1,700,000) 372,979 436,544 468,656 502,342 576,768 655,598

Discounted

operating

cashflow (1,700,000) 336,775 355,911 345,003 333,906 346,165 355,284

Discounted payback 4.95 Years

Average return on investment 30%

IRR 17%

Profitability Index 1.22

NPV 373,043 Baht

EA 87,545 Baht

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