Solutions to Questions
12-1 Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as having a positive net present value. Capital budgeting preference decisions relate to choosing between several competing courses of action, such as which of two machines to purchase.
12-8 The cost of capital is often used as the hurdle that must be cleared before an investment project will be accepted. When this is done, the cost of capital is used as the discount rate in discounted cash flow analysis. If the net present value of a project is positive, then the project is acceptable, since its rate of return is greater than the cost of capital.
12-2 The term “time value of money” refers to the fact that a dollar received today is more valuable than a dollar received in the future. A dollar received today can be invested to generate a return, yielding more than a dollar in the future.
12-3 Discounting is the process of computing the present value of a future cash flow. The concept gives specific recognition to the time value of money in investment decisions.
12-9 No. As the discount rate increases, the present value of a given future cash flow decreases. For example, the factor for a discount rate of 12% for cash to be received ten years from now is 0.322, whereas the factor for a discount rate of 14% over the same period is
0.270. If the cash to be received in ten years was $10,000, the present value in the first case would be $3,220, but only $2,700 in the second case. Thus, as the discount rate increases, the present value of a given cash flow decreases.
12-4 The net present value method is superior to the payback and simple rate of return methods because it recognizes the time value of money.
12-10 The return is more than 14% because the net present value is positive. In order for the rate of return to be exactly 14%, the net present value would have to be zero.
12-5 Net present value is the present value of cash inflows less the present value of cash outflows. The net present value can be negative if the present value of the outflows is greater than the present value of the inflows.
12-11 Preference decisions are sometimes called rationing decisions because funds available for investment are often limited and it is necessary to ration these funds among many competing investment opportunities.
12-6 No. Cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the costs of all sources of financing, both debt and equity.
12-12 The project profitability index is computed by dividing a project’s net present value by the required investment. The index measures the profitability provided for each dollar invested in the project. 12-7 The internal rate of return on an investment is the rate of return over the project’s useful life. It is computed by finding the discount rate that equates the present value of a project’s cash inflows with the present value of its cash outflows.
12-13 The payback period is the length of time required for an investment to recoup its own initial cost out of the cash receipts that it generates.
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526 Introduction to Managerial Accounting, 4th Edition

12-14 The payback method can help the manager by acting as a screening tool in weeding out investment proposals. If a proposal doesn’t provide a payback within some specified period, there may be no need to consider it further.
Also, the payback method is often very useful to companies that are experiencing difficulties in maintaining a strong cash position. It can help identify projects that will return the initial investment very quickly. Also, the payback method is often used in industries where products become obsolete very rapidly.
12-15 Both the payback and the simple rate of return methods ignore the time value of money.
A dollar received today is weighed equally with a dollar received in the future. Furthermore, the payback method ignores all cash flows that occur after the initial investment has been recovered.
Solutions Manual, Chapter 12
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527

Brief Exercise 12-1 (15 minutes)
1.
Item Year(s) Cash Flow
14%
Factor
Present
Value of
Cash
Flows
2.
Annual cost savings .. 1-10 $4,000 5.216 $ 20,864
Initial investment ..... Now $(25,000) 1.000 (25,000)
Net present value ..... $ (4,136)
Item
Cash
Flow Years
Total
Cash
Flows
Annual cost savings .. $4,000 10 $ 40,000
Initial investment ..... $(25,000) 1 (25,000)
Net cash flow ........... $ 15,000
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528 Introduction to Managerial Accounting, 4th Edition

Brief Exercise 12-2 (20 minutes)
Item Year(s)
Amount of
Cash Flows
16%
Factor
Present
Value of
Cash Flows
Project A:
Investment required . Now $(15,000) 1.000 $(15,000)
Annual cash inflows .. 1-10
Net present value .....
Project B:
Single cash inflow ....
Net present value .....
10
$4,000 4.833 19,332
$ 4,332
$60,000 0.227 13,620
$ (1,380)
Project A should be selected. Project B does not provide the required 16% return, as shown by its negative net present value.
Investment required . Now $(15,000) 1.000 $(15,000)
Solutions Manual, Chapter 12
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529

Brief Exercise 12-3 (15 minutes)
1. The project profitability index for each proposal is:
Proposal
Net Present
Value
(a)
A
B
C
D
$34,000
$50,000
$45,000
$51,000
2. The ranking would be:
Project
Profitability
Investment
Required
(b)
$85,000
$200,000
$90,000
$170,000
Project
Profitability
Index
(a) ÷ (b)
0.40
0.25
0.50
0.30
Proposal Index
C
A
D
B
0.50
0.40
0.30
0.25
Note that proposal D has the highest net present value, but it ranks third in terms of the project profitability index.
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530 Introduction to Managerial Accounting, 4th Edition

Brief Exercise 12-4 (15 minutes)
1. The payback period is determined as follows:
Year Investment
1
2
Cash
Inflow
Unrecovered
Investment
$38,000 $2,000 $36,000
$6,000 $4,000 $38,000
3
4
5
6
7
8
9
10
$8,000 $30,000
$9,000 $21,000
$12,000 $9,000
$10,000
$8,000
$6,000
$5,000
$5,000
$0
$0
$0
$0
$0
The investment in the project is fully recovered in the 6th year. To be more exact, the payback period is approximately 6.9 years.
2. Since the investment is recovered prior to the last year, the amount of the cash inflow in the last year has no effect on the payback period.
Solutions Manual, Chapter 12
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531

Brief Exercise 12-5 (15 minutes)
The annual incremental net operating income is determined by comparing the operating cost of the old machine to the operating cost of the new machine and the depreciation that would be taken on the new machine:
Operating cost of old machine ...................... $33,000
Less operating cost of new machine ............. 10,000
Less annual depreciation on the new machine
($80,000 ÷ 10 years) ................................ 8,000
Annual incremental net operating income ..... $15,000
Cost of the new machine ............................. $80,000
Less scrap value of old machine ................... 5,000
Initial investment ......................................... $75,000
=
Annual incremental net operating income
Initial investment
$15,000
$75,000
= 20%
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532 Introduction to Managerial Accounting, 4th Edition

Brief Exercise 12-6 (30 minutes)
1. a. $400,000 × 0.794 (Table 12B-1) = $317,600.
b. $400,000 × 0.712 (Table 12B-1) = $284,800.
2. a. $5,000 × 4.355 (Table 12B-2) = $21,775.
b. $5,000 × 3.685 (Table 12B-2) = $18,425.
3. From Table 12B-2, the factor for 10% for 20 years is 8.514. Thus, the present value of Sally’s winnings is:
$50,000 × 8.514 = $425,700.
Whether or not Sally really won a million dollars depends on your point of view. She will receive a million dollars over the next 20 years; however, in terms of its value right now she won much less than a million dollars as shown by the present value computation above.
Solutions Manual, Chapter 12
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533

Exercise 12-7 (15 minutes)
Amount of Cash
Flows
12%
Factor
Present
Value of
Cash
Flows
Purchase of the stock .... Now $(18,000) 1.000 $(18,000)
Annual dividends*.........
Sale of the stock ...........
Net present value .........
Year(s)
1-4
4
$720 3.037 2,187
$22,500 0.636 14,310
$(1,503)
*900 shares × $0.80 per share per year = $720 per year.
No, Mr. Critchfield did not earn a 12% return on the stock. The negative net present value indicates that the rate of return on the investment is less than the minimum required rate of 12%.
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534 Introduction to Managerial Accounting, 4th Edition

Exercise 12-8 (30 minutes)
1. The formula for the project profitability index is:
Project profitability index =
Net present value
Investment required
The index for the projects under consideration would be:
Project 1: $87,270 ÷ $480,000 = 0.18
Project 2: $73,400 ÷ $360,000 = 0.20
Project 3: $66,140 ÷ $270,000 = 0.24
Project 4: $72,970 ÷ $450,000 = 0.16
2. a. and b.
Project
Profitability
First preference ........
Second preference ....
Third preference .......
Fourth preference .....
Net Present
Value
1
2
4
3
Index
3
2
1
4
3. The net present value is inferior to the project profitability index as a ranking device because it does not properly consider the amount of investment. For example, it ranks project #3 as fourth because of its low net present value; yet this project is the best in terms of the amount of cash inflow generated for each dollar of investment (as shown by the project profitability index).
Solutions Manual, Chapter 12
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535

Exercise 12-9 (20 minutes)
1. The payback period would be:
Payback Period =
Investment required
Net annual cash inflow
=
$180,000
$37,500 per year
= 4.8 years
No, the equipment would not be purchased, since the 4.8-year payback period exceeds the company’s maximum 4-year payback period.
2. The simple rate of return would be computed as follows:
Annual cost savings ............................................... $37,500
Less annual depreciation ($180,000 ÷ 12 years)...... 15,000
Annual incremental net operating income ............... $22,500
Simple rate of return =
=
Annual incremental net operating income
Initial investment
$22,500
$180,000
= 12.5%
The equipment would not be purchased since its 12.5% rate of return is less than the company’s 14% required rate of return.
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536 Introduction to Managerial Accounting, 4th Edition

Exercise 12-10 (30 minutes)
Item Year(s)
Amount of Cash
Flows
14%
Factor
Present
Value of
Cash
Flows
Cost of new equipment ............ Now $(850,000) 1.000 $(850,000)
Working capital required .......... Now $(100,000) 1.000 (100,000)
Net annual cash receipts .......... 1-5 $230,000 3.433 789,590
Cost of road repairs ................. 3 $(60,000) 0.675 (40,500)
Salvage value of equipment ...... 5 $200,000 0.519 103,800
Working capital released .......... 5 $100,000 0.519 51,900
Net present value .................... $ (45,210)
No, the project should not be accepted; it has a negative net present value.
This means that the rate of return on the investment is less than the company’s required rate of return of 14%.
Solutions Manual, Chapter 12
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537

Exercise 12-11 (20 minutes)
Item Year(s)
Amount of Cash
Flows
20%
Factor
Present
Value of
Cash
Flows
Project A:
Cost of equipment required ...... Now $(300,000) 1.000 $(300,000)
Annual cash inflows ................. 1-7
Salvage value of the equipment
Net present value ....................
Project B:
7
$80,000 3.605 288,400
$20,000 0.279 5,580
$ (6,020)
Working capital investment ...... Now $(300,000) 1.000 $(300,000)
Annual cash inflows ................. 1-7 $60,000 3.605 216,300
Working capital released ..........
Net present value ....................
7 $300,000 0.279 83,700
$ 0
The $300,000 should be invested in Project B rather than in Project A.
Project B has a zero net present value, which means that it promises exactly a 20% rate of return. Project A is not acceptable at all, since it has a negative net present value.
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538 Introduction to Managerial Accounting, 4th Edition

Problem 12-12A (30 minutes)
1. The net annual cash inflows would be:
Reduction in annual operating costs:
Operating costs, present hand method ............... $24,000
Operating costs, new machine ........................... 6,500
Annual savings in operating costs ...................... 17,500
Increased annual contribution margin:
5,500 boxes × $2.10 per box ............................. 11,550
Total net annual cash inflows ............................... $29,050
2.
18%
Factor
Present
Value of
Item Year(s)
Amount of
Cash Flows Cash Flows
Cost of the machine .......... Now $(100,000) 1.000 $(100,000)
Replacement of parts ......... 5 $(7,000) 0.437 (3,059)
Annual cash inflows
(above) .......................... 1-10
Salvage value .................... 10
Net present value ..............
$29,050 4.494
$6,000 0.191
130,551
1,146
$ 28,638
Solutions Manual, Chapter 12
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539

Problem 12-13A (30 minutes)
1. The project profitability index is computed as follows:
Net Present
Value
Project (a)
A ........... $42,000
B ........... $49,400
C ........... $49,000
D ........... $31,740
2. a. and b.
Investment
Required
(b)
$140,000
$190,000
$175,000
$138,000
Project
Profitability
Index
(a) ÷ (b)
0.30
0.26
0.28
0.23
First preference ........
Second preference ....
Third preference .......
Fourth preference .....
Net Present
Value
B
C
A
D
Project
Profitability
Index
A
C
B
D
3. The net present value is inferior to the project profitability index as a ranking device, because it looks only at the total amount of net present value from a project and does not consider the amount of investment required. For example, project A is ranked third on the basis of net present value; yet this project is ranked first in terms of the amount of cash inflow generated for each dollar of investment (as shown by the project profitability index).
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540 Introduction to Managerial Accounting, 4th Edition

Problem 12-14A (45 minutes)
1. The total-cost approach:
Item Year(s)
Amount of
Cash Flows
16%
Factor
Present
Value of
Cash Flows
Purchase the new truck:
Initial investment—new truck ............................. Now $(42,000) 1.000 $(42,000)
Salvage of the old truck .... Now $10,000 1.000 10,000
Annual cash operating costs ............................. 1-10 $(11,000) 4.833 (53,163)
$4,000 0.227 908 Salvage of the new truck ... 10
Present value of the net cash outflows ..................
Keep the old truck:
Overhaul needed now ........ Now
$(84,255)
$(9,500) 1.000 $ (9,500)
Annual cash operating costs .............................. 1-10 $(14,000) 4.833 (67,662)
$2,000 0.227 454 Salvage of the old truck ...... 10
Present value of the net cash outflows ..................
Net present value in favor of keeping the old truck .........
$ (76,708)
$ 7,547
The company should keep the old truck.
Solutions Manual, Chapter 12
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541

Problem 12-14A (continued)
2. The incremental-cost approach:
Item Year(s)
Amount of
Cash
Flows
16%
Factor
Present
Value of
Cash Flows
Incremental investment—new truck* ................................. Now $(32,500) 1.000 $(32,500)
Salvage of the old truck .......... Now $10,000 1.000
Savings in annual cash
$3,000 4.833
10,000
14,499 operating costs .................... 1-10
Difference in salvage value in
10 years .............................. 10
Net present value in favor of keeping the old truck ...........
$2,000 0.227 454
$ (7,547)
*$42,000 – $9,500 = $32,500. The $10,000 salvage value now of the old truck could also be deducted, leaving an incremental investment for the new truck of only $22,500.
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542 Introduction to Managerial Accounting, 4th Edition

Problem 12-15A (45 minutes)
1. Average weekly use of the auto wash and the vacuum will be:
Auto wash:
$1,110
$1.50
= 740 uses; Vacuum: 740 × 70% = 518 uses
The expected annual net cash flow will be:
Auto wash cash receipts ($1,110 per week × 52 weeks) ...............................................................
Vacuum cash receipts (518 vacuumings per week ×
$0.25 per vacuuming × 52 weeks) .......................
Total cash receipts .................................................
Less cash disbursements:
Washer (740 washings per week × $0.23 per washing × 52 weeks) ....................................... $ 8,850
Electricity (518 vacuumings per week × $0.10 per vacuuming × 52 weeks) ................................... 2,694
$57,720
6,734
64,454
2.
Rent ($1,200 per month × 12 months) ................ 14,400
Cleaning ($780 per month × 12 months) ............. 9,360
Insurance ($60 per month × 12 months) ............. 720
Maintenance ($510 per month × 12 months) ....... 6,120
Total cash disbursements .......................................
Annual net cash flow .............................................
Amount of
Cash
42,144
$22,310
Present
Value of
Item Year(s) Flows
12%
Factor Cash Flows
Cost of equipment ............... Now $(110,000) 1.000 $(110,000)
Working capital needed ....... Now $(1,800) 1.000
Annual net cash flow
(1,800)
(above) ............................ 1-10 $22,310 5.650 126,052
Salvage of equipment .......... 10
Working capital released ...... 10
Net present value ................
$11,000 0.322 3,542
$1,800 0.322 580
$ 18,374
Yes, Jerry should open the car wash. It promises more than a 12% rate of return.
Solutions Manual, Chapter 12
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543

Problem 12-16A (45 minutes)
1. The annual incremental net operating income can be determined as follows:
Ticket revenue ...........................
Less operating expenses:
Salaries ................................... $115,000
Total operating expenses ............
Net operating income .................
*$500,000 ÷ 10 years = $50,000 per year.
2. The simple rate of return is:
$320,000
Insurance ................................ 28,200
Utilities .................................... 12,000
Depreciation* .......................... 50,000
Maintenance ............................ 32,000
237,200
$ 82,800
Annual incremental net operating income
Initial investment (net of salvage from old equipment)
=
$82,800
$500,000 - $40,000
=
$82,800
$460,000
= 18.0%
Yes, the water slide would be constructed. Its return is greater than the specified hurdle rate of 15%.
3. The payback period would be:
=
Investment required (net of salvage from old equipment)
Net annual cash inflow
$500,000 - $40,000
$132,800*
=
$460,000
$132,800*
= 3.46 years (rounded)
*Net operating income+ Depreciation = $82,800 + $50,000 = $132,800
Yes, the water slide would be constructed. The payback period is within the maximum 5 years Otthar requires.
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544 Introduction to Managerial Accounting, 4th Edition

Problem 12-17A (45 minutes)
The net annual cash inflow from rental of the property would be:
Net operating income .......... $30,100
Add back depreciation ......... 17,800
Net annual cash inflow ........ $47,900
Given this figure, the present value analysis would be as follows:
Amount of Cash
Flows
Present
Value of
Cash
Flows Item
Keep the property:
Year(s)
14%
Factor
Annual loan payment ...... 1-10 $(12,600) 5.216 $ (65,722)
Net annual cash inflow .... 1-16 $47,900 6.265 300,094
Resale value of the property ......................
Present value of cash flows ...........................
16 $139,600 * 0.123 17,171
$251,543
Sell the property:
Payoff of mortgage ......... Now $(71,000) 1.000 $ (71,000)
Down payment received .. Now $150,000 1.000 150,000
Annual payments received ...................... 1-16 $23,000 6.265 144,095
Present value of cash flows ........................... $223,095
Net present value in favor of keeping the property ... $ 28,448
*Land: $52,000 × 2.5 = $130,000; Building: $9,600; Total: $139,600.
Thus, Professor Ryatt should be advised to keep the property. Note that even if the property were worth nothing at the end of 16 years, it would still be more desirable to keep the property rather than sell it under the terms offered by the realty company.
Solutions Manual, Chapter 12
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545

Problem 12-18A (60 minutes)
1. A net present value computation for each investment follows:
Item Year(s)
Common stock:
Purchase of the stock ........ Now
Sale of the stock ............... 4
Net present value ..............
Preferred stock:
Purchase of the stock ........ Now
Annual cash dividend
(6%).............................. 1-4
Sale of the stock ............... 4
Net present value ..............
Bonds:
Purchase of the bonds ....... Now
Semiannual interest received ......................... 1-8*
Amount of
Cash Flows
20%
Factor
Present
Value of
Cash Flows
$(80,000) 1.000 $(80,000)
$180,000 0.482 86,760
$ 6,760
$(30,000) 1.000 $(30,000)
$1,800 2.589 4,660
$24,000 0.482 11,568
$(13,772)
$(50,000) 1.000 $(50,000)
$3,000 5.335** 16,005
Sale of the bonds .............. 8*
Net present value ..............
$58,500 0.467** 27,320
$ (6,675)
* 8 semiannual interest periods.
** Factor for 8 periods at 10%. (As stated in the text, we must halve the discount rate and double the number of periods.)
Anita earned a 20% rate of return on the common stock, but not on the preferred stock or the bonds.
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546 Introduction to Managerial Accounting, 4th Edition

Problem 12-18A (continued)
2. Considering all three investments together, Anita did not earn a 20% rate of return. The computation is:
Net
Present
Value
Common stock ........................ $ 6,760
Preferred stock ........................ (13,772)
Bonds ..................................... (6,675)
Overall net present value ......... $(13,687)
The defect in the broker’s computation is that it does not consider the time value of money and therefore has overstated the rate of return earned.
3. Because the assumption is that the project will yield the same annual cash inflow every year, the formula for the net present value of the project is:
Net present Present value Annual the project an annuity inflow
Investment
Substituting the $262,500 investment and the factor for 16% for 10 periods into this formula and requiring that the net present value be positive, we get:
4.833 × Annual cash inflow – $262,500 > 0
Therefore, the required net annual cash inflow would be at least:
Annual cash inflow > $262,500 ÷ 4.833 = $54,314
Solutions Manual, Chapter 12
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547

Problem 12-19A (60 minutes)
1. a. Sales revenue .............................................
Less variable production expenses (@ 20%) .
Contribution margin ....................................
Less fixed expenses:
Advertising ............................................... $42,000
Salaries .................................................... 86,000
Utilities .................................................... 9,000
Insurance ................................................. 13,000
$350,000
70,000
280,000
Depreciation* ........................................... 58,500
Total fixed expenses ....................................
Net operating income ..................................
208,500
$ 71,500
* [$780,000 – (25% × $780,000)] ÷ 10 years = $58,500 per year
b. The formula for the simple rate of return is:
=
Annual incremental net operating income
Initial investment
$71,500
$780,000
= 9.2%
c. The formula for the payback period is:
Payback period =
Investment required
Net annual cash inflow
=
$780,000
$130,000 per year*
= 6.0 years
*Net annual cash inflow = Net operating income + Depreciation
= $71,500 + $58,500 = $130,000
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548 Introduction to Managerial Accounting, 4th Edition

Problem 12-19A (continued)
2. a. A cost reduction project is involved here, so the formula for the simple rate of return would be:
Simple rate of return =
Cost savings - Depreciation
Initial
-
Salvage from investment old equipment
The reduction in costs with the new equipment would be:
Annual costs, old equipment ................
Annual costs, new equipment:
$85,000
Salary of operator ............................. $26,000
Maintenance ..................................... 3,000 29,000
Annual savings in costs ........................ $56,000
Thus, the simple rate of return would be:
$56,000 - $22,000*
$220,000 - $7,200
=
$34,000
$212,800
= 16.0%
*$220,000 ÷ 10 years = $22,000 per year
b. The formula for the payback period remains the same as in Part (1), except we must reduce the investment required by the salvage from sale of the old equipment:
Payback period =
Investment required
-
Salvage from old equipment
Net annual cash inflow
=
$220,000 - $7,200
$56,000 per year*
= 3.8 years
*See Part (2a) above.
3. According to the company’s criteria, machine A should not be purchased and machine B should be purchased.
Solutions Manual, Chapter 12
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549

Communication in Practice
Date: Current date
To:
From:
Instructor
Student’s Name
Subject: Capital Budgeting Discussion with
Controller or Chief Financial Officer
In addition to summarizing general information about the company (that was obtained from the company’s web site), each student’s memorandum should address the following:
1. The nature of the capital project.
2. The total cost of the capital project.
3. Whether or not the project costs stayed within budget.
4. The financial criteria used to evaluate the project.
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550 Introduction to Managerial Accounting, 4th Edition

Teamwork in Action
1. This is a least-cost problem; it can be worked either by the total-cost approach or by the incrementalcost approach. Regardless of which approach is used, we must first compute the annual production costs that would result from each of the machines. The computations are:
Year
3 4-10 1 2
Units produced ........................................... 20,000 30,000 40,000 45,000
Model 2600: Total cost at $0.90 per unit ...... $18,000 $27,000 $36,000 $40,500
Model 5200: Total cost at $0.70 per unit ...... $14,000 $21,000 $28,000 $31,500
Using these data, the solution by the total-cost approach would be:
18%
Factor Item Year(s)
Amount of
Cash Flows
Present Value of Cash Flows
Alternative 1: Purchase the model 2600 machine:
Cost of new machine ......................................... Now $(180,000) 1.000 $(180,000)
Cost of new machine ......................................... 6 $(200,000) 0.370
Market value of replacement machine................. 10 $100,000 0.191
Production costs (above) ...................................
" " .....................................................
" " .....................................................
1
2
3
" " ..................................................... 4-10
$(18,000) 0.847
$(27,000) 0.718
$(36,000) 0.609
$(40,500) 2.320 *
(74,000)
19,100
(15,246)
(19,386)
(21,924)
(93,960)
Repairs and maintenance ................................... 1-10 $(6,000) 4.494 (26,964)
Present value of cash outflows ........................... $(412,380)
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551

Teamwork in Action (continued)
Item Year(s)
Amount of
Cash Flows
18%
Factor
Present Value of Cash Flows
Alternative 2: Purchase the model 5200 machine:
Cost of new machine .................................... Now $(250,000) 1.000 $(250,000)
Production costs (above) .............................. 1 $(14,000) 0.847 (11,858)
" " ................................................
" " ................................................
" " ................................................ 4-10 $(31,500) 2.320 * (73,080)
Repairs and maintenance .............................. 1-10 $(4,600) 4.494 (20,672)
Present value of cash outflows ......................
2 $(21,000) 0.718
3 $(28,000) 0.609
(15,078)
(17,052)
Net present value in favor of Alternative 2 ........
$(387,740)
$ 24,640
* Present value factor for 10 periods ......................................................... 4.494
Present value factor for 3 periods ......................................................... 2.174
Present value factor for 7 periods starting 4 periods in the future ........... 2.320
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552 Introduction to Managerial Accounting, 4th Edition

Teamwork in Action (continued)
The solution by the incremental-cost approach would be:
Item Year(s)
Amount of Cash
Flows
18%
Factor
Present
Value of
Cash
Flows
Incremental cost of the model 5200 machine ........... Now $ (70,000) 1.000 $ (70,000)
Cost avoided on a replacement model 2600
$200,000 0.370 74,000 machine ............................. 6
Salvage value forgone on the replacement machine .......... 10 $(100,000) 0.191 (19,100)
Savings in production costs .... 1
" " " .................... 2
" " " .................... 3
" " " .................... 4-10
$4,000 0.847
$6,000 0.718
$8,000 0.609
$9,000 2.320
3,388
4,308
4,872
20,880
Savings on repairs and maintenance costs .............. 1-10
Net present value ..................
$1,400 4.494 6,292
$ 24,640
Therefore, the company should purchase the model 5200 machine and keep the presently owned model 2600 machine on standby.
2. An increase in materials cost would make the model 5200 machine less desirable. The reason is that it uses more materials per unit than does the model 2600 machine, as evidenced by the greater materials cost per unit.
3. An increase in labor cost would make the model 5200 machine more desirable. The reason is that it uses less labor time per unit than does the model 2600 machine, as evidenced by the lower labor cost per unit.
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553

Analytical Thinking Case (75 minutes)
1. Some students will have difficulty organizing the data into a coherent format. Perhaps the clearest approach is as follows:
Item Year(s)
Amount of
Cash Flows
12%
Factor
Present Value of Cash Flows
Purchase of facilities:
Initial payment .......... Now $(6,000,000) 1.000 $ (6,000,000)
Annual payments ....... 1-4 $(2,000,000) 3.037 (6,074,000)
Annual cash operating
$(200,000) 7.469 (1,493,800) costs ...................... 1-20
Resale value of facilities .................. 20
Present value of cash flows ......................
$5,000,000 0.104 520,000
Lease of facilities:
Initial deposit ............ Now maintenance ........... 1-20
Return of deposit ....... 20
Present value of cash flows ......................
$(13,047,800)
$(400,000) 1.000 $ (400,000)
First lease payment .... Now $(1,000,000) 1.000 (1,000,000)
Remaining lease payments ............... 1-19 $(1,000,000) 7.366 (7,366,000)
Annual repair and
$(50,000) 7.469 (373,450)
$400,000 0.104 41,600
Net present value in favor of leasing the facilities .....................
$ (9,097,850)
$ 3,949,950
This is a least-cost decision. In this particular case, the simplest way to handle the data is the total-cost approach as shown above. The problem with Harry Wilson’s approach, in which he simply added up the payments, is that it ignores the time value of money. The purchase option ties up large amounts of funds that could be earning a return elsewhere.
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554 Introduction to Managerial Accounting, 4th Edition

Analytical Thinking Case (continued)
The incremental-cost approach is another way to organize the data, although it is harder to follow and would not be as clear in a presentation to the executive committee. The data could be arranged as follows (students are likely to have many variations):
12%
Factor
Present
Value of
Item Year(s)
Amount of
Cash Flows Cash Flows
Initial payment avoided 1 .. Now $5,000,000 1.000 $ 5,000,000
Deposit ........................... Now $(400,000) 1.000 (400,000)
Annual purchase payments avoided ......... 1-4 $2,000,000 3.037 6,074,000
Annual lease payments .... 1-19 $(1,000,000) 7.366 (7,366,000)
Cash operating cost
$150,000 7.469 1,120,350 savings 2 ....................... 1-20
Forgone resale value of facilities, net of the return of deposit 3 .......... 20 $(4,600,000) 0.104 (478,400)
Net present value in favor of leasing the facilities ...
1
$ 3,949,950
2
3
$6,000,000 – $1,000,000 = $5,000,000
$200,000 – $50,000 = $150,000
$5,000,000 – $400,000 = $4,600,000
2. The present value of $5 million in 20 years is only $520,000 if the company can invest its funds at 12%. Money to be received far into the future is worth very little in terms of present value when the discount rate is high. The facility’s future value would have to be more than
$37,980,000 (= $3,949,950 ÷ 0.104) higher than Harry Wilson has assumed to overturn the conclusion that leasing is the more attractive alternative.
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