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CHAPTER 27

LONGER-RUN DECISIONS: CAPITAL BUDGETING

Changes from Eleventh Edition


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.

Rock Creek Golf Club is a buy-or-lease case, with tax aspects.

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

Accounting income before disposal..............................................................................................................................................


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

Calculation of cash flow


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.

(1) $30,000/5 years, or $6,000 per year


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

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Problem 27-3: Corrine Company


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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Problem 27-5: Wellington Corporation


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):

1990 1991 1992


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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c. 1990 Net income............................................................................................................................


$ 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

d. The project should be adopted if a 20% after-tax rate of return is required:

Present value of cash flows at 20%:


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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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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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:

PV of cash savings of $160,000/year for 5 years = $160,000 * .60 * 3.993.............................................................


$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.

ACRS Allowance PV factor ratio

Year 1 175,000 .926 $162,050

2 130,000 .857 $111,410

3 75,000 .794 $59,550

4 60,000 .735 $44,100

5 60,000 .681 $40,860

$417,970

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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

Decision: Do not purchase, since NPV = - $3,559.

*This is the difference between 3.352 and 2.283

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.

Moral: The time pattern of earnings makes a difference.

3. Investment, net of ITC...........................................................................................................................................................


$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).

Case 27-2: Rock Creek Golf Club*


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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2 Depreciation tax shield........................................................................................................................................


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.

1. $200 * 40 carts * .34 tax rate

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

3. $420 * 40 carts * (1 - .34)

4. $500 * 40 carts * (1 - .34)

5. Year Depreciation Tax Shield (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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Note: This case is unchanged from the Eleventh Edition.

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.

Possible conflict in project rankings on the basis of NPV and IRR.

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

Identification of key value drivers for performing sensitivity analysis.

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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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

(a) Payback period (see note)


Advantages Disadvantages

Is simple and easy to understand Ignores the time value of money

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

Serves as a useful indicator of a projects Selection of the maximum acceptable payback


riskiness and liquidity period is arbitrary

(b) Average return on investment


(=Average annual cashflow after taxes/ Net investment)
Advantages Disadvantages

Is simple and easy to understand Ignores time value of money

Can be used as a rough screening tool

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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

(c) Internal rate of return (IRR)


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

Requires detailed long-term forecast of


incremental costs and benefits

Implicitly assumes that the intermediate


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

Takes into account the time value of money and


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

Takes into account the time value of money

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

Where Kc = corporate cost of capital


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%

12
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

Payback 2.46 years 3.84 years


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

Equivalent annuity (EA)1 52,906 baht 87,545 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

Amount of upfront investment

Cost of capital

Equivalent Annuity (in baht)


Sensitivity Analysis: patronage factor

Patronage factor [see Exhibits Lease Option EA Build Option EA (baht) Decision
TN-1 & 2] (baht)

0 1,263,950 1,332,436 Build


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

0.5 (base) 52,906 87,545 Build


0.75 (552,616) (534,901) Reject both
1 (1,158,138) (1,157,347) Reject both

Sensitivity Analysis: upfront investment

% increase in upfront Lease Option EA Build Option EA (baht) Decision


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

Sensitivity Analysis: cost of capital

Cost of capital Lease Option EA Build Option EA (baht) Decision


(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

Patronage 8% 10.75% 12% 14% 16% 18%


Factor

0 1,370,536 1,332,436 1,314,853 1,286,391 1,257,545 1,228,335

0.25 746,546 709,990 693,092 665,706 637,910 609,723

0.5 122,557 87,545 71,332 45,022 18,274 (8,889)

0.75 (501,433) (534,901) (550,428) (575,663) (601,361) (627,501)

1 (1,125,422) (1,157,347) (1,172,189) (1,196,348) (1,220,996) (1,246,114)

14
2007 McGraw-Hill/Irwin Chapter 27

The Lease Option

Cost of capital

Patronage 8% 10.75% 12% 14% 16% 18%


Factor

0 1,279,229 1,263,950 1,256,911 1,245,531 1,234,011 1,222,356

0.25 672,952 658,428 651,724 640,869 629,862 618,706

0.5 66,676 52,906 46,536 36,207 25,712 15,057

0.75 (539,601) (552,616) (558,651) (568,455) (578,437) (588,592)

1 (1,145,877) (1,158,138) (1,163,838) (1,173,117) (1,182,587) (1,192,241)

Difference in Equivalent Annuity (in baht)


[Build - Lease]

Cost of capital

Patronage 8% 10.75% 12% 14% 16% 18%


Factor

0 91,307 68,486 57,942 40,860 23,534 5,979

0.25 73,594 51,562 41,368 24,837 8,048 (8,983)

0.5 55,881 34,639 24,796 8,815 (7,438) (23,946)

0.75 38,168 17,715 8,223 (7,208) (22,924) (38,909)

1 20,455 791 (8,351) (23,231) (38,409) (53,873)

EXHIBIT TN-1
THE LEASE OPTION: PLANET KARAOKE PUB ANALYSIS OF OPERATING CASHFLOW

Project life 4 years


Renovation cost 770,000 baht
Tax rate 30%
Cost of capital 10.75%
Increase in repairs & maintenance 10,000 baht
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%

15
Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

(Figures in baht except where otherwise stated)


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)

NOPAT 131,250 108,150 120,663 58,800


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

* Net room revenue = Room revenue - Room operating expenses

Payback 2.46 Years


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

Project life 6 years


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)

NOPAT 372,979 436,544 468,656 502,342 576,768 655,598


Add:
Depreciation 283,333 283,333 283,333 283,333 283,333 283,333

656,312 719,878 751,989 785,675 860,102 938,932


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

Payback 3.84 Years


Discounted payback 4.95 Years
Average return on investment 30%
IRR 17%
Profitability Index 1.22
NPV 373,043 Baht
EA 87,545 Baht