Appendix
Capital Investment Decisions: An Overview
Solutions to Review Questions
A-1.
The timing is important because cash received earlier has a greater economic
value than cash received later. There is an opportunity cost and risk involved by
having funds tied up in capital investment projects. Determining the amount is
important in estimating the future cash flows. The timing and amount together are
used to determine the economic value of the project.
A-2.
The time value of money merely states that cash received earlier has a greater
value than cash received later because the dollar received today can be earning
interest between now and later.
A-3.
Revenues represent the accounting measure of inflows to the firm. Revenues
might be recognized when, before, or after cash is received. Revenues are
recognized based on generally accepted accounting principles.
A-4.
Expenses represent the accounting measure of outflows from the firm. Expenses
are matched with revenues and, therefore, might be recognized when, before, or
after cash is spent.
A-5.
Depreciation is an accounting measure of the use of a capital asset and is not a
cash flow. The tax shield on depreciation is the savings in taxes associated with
the depreciation expense recorded for tax purposes and is a cash flow.
,Solutions to Critical Analysis and Discussion Questions
A-6.
To determine which, if either, project should be approved, the net present value
of each project should be determined. Once the timing and amount of cash flows
has been determined, they should be discounted to the present by determining
and applying appropriate discount rates. Any project with a positive net present
value could be justified and the project with the greater net present value should
be approved under normal circumstances.
A-7.
The four types of cash flows are:
(1) investment cash flows,
(2) periodic operating flows,
(3) depreciation tax shield, and
(4) disinvestment flows.
We consider them separately because each type of flow results from different
activities and gives rise to different tax consequences.
A-8.
No. Depreciation is not a cash flow item. However, the tax shield which arises
from depreciation deductions for tax purposes is a cash flow item and is included.
A-9.
The total amount depreciated over the life of the machine (and, therefore, often
the tax savings associated with that depreciation) is the same regardless of the
depreciation method used. However, for capital investment decisions, the timing
of the savings is important because it affects the net present value of the
depreciation tax shield.
A-10.
Although the working capital might be assumed to be returned to the firm at the
end of the project, the firm does not have the use of those funds during that time.
Therefore, the present value of the working capital returned is less than the
present value of the working capital contributed.
,A-11.
The net present value analysis for a new plant considered in this appendix
considers the cash flows from the entire life of the plant and compares the
present value of those cash flows to the initial investment in the plant. Accounting
measures of income use a measure of plant cost (depreciation), which is an
allocation of the plant cost to the individual years. This allocation often does not
depend on the actual usage of the plant. Therefore, plants that are built with the
intention of growing output to future demand will have insufficient cash inflows in
the first year to cover the depreciation cost. Accounting income, therefore will be
low (or negative)..
, Solutions to Exercises
A-12. (20 min.) Present Value of Cash Flows: Star City.
a. At 20%
Time Year
0 1 2 3 4 5
Net cash flow............. ($200,000) $20,000 $50,000 $80,000 $80,000 $100,000
PV factor (20%) ......... 1.000 .833 .694 .579 .482 .402
Present values .......... ($200,000) $16,660 $34,700 $46,320 $38,560 $ 40,200
Net PV of project ....... ($ 23,560)
b. At 12%
Time Year
0 1 2 3 4 5
Net cash flow............. ($200,000) $20,000 $50,000 $80,000 $80,000 $100,000
PV factor (12%) ......... 1.000 .893 .797 .712 .636 .567
Present values .......... ($200,000) $17,860 $39,850 $56,960 $50,880 $ 56,700
Net PV of project ....... $ 22,250
Capital Investment Decisions: An Overview
Solutions to Review Questions
A-1.
The timing is important because cash received earlier has a greater economic
value than cash received later. There is an opportunity cost and risk involved by
having funds tied up in capital investment projects. Determining the amount is
important in estimating the future cash flows. The timing and amount together are
used to determine the economic value of the project.
A-2.
The time value of money merely states that cash received earlier has a greater
value than cash received later because the dollar received today can be earning
interest between now and later.
A-3.
Revenues represent the accounting measure of inflows to the firm. Revenues
might be recognized when, before, or after cash is received. Revenues are
recognized based on generally accepted accounting principles.
A-4.
Expenses represent the accounting measure of outflows from the firm. Expenses
are matched with revenues and, therefore, might be recognized when, before, or
after cash is spent.
A-5.
Depreciation is an accounting measure of the use of a capital asset and is not a
cash flow. The tax shield on depreciation is the savings in taxes associated with
the depreciation expense recorded for tax purposes and is a cash flow.
,Solutions to Critical Analysis and Discussion Questions
A-6.
To determine which, if either, project should be approved, the net present value
of each project should be determined. Once the timing and amount of cash flows
has been determined, they should be discounted to the present by determining
and applying appropriate discount rates. Any project with a positive net present
value could be justified and the project with the greater net present value should
be approved under normal circumstances.
A-7.
The four types of cash flows are:
(1) investment cash flows,
(2) periodic operating flows,
(3) depreciation tax shield, and
(4) disinvestment flows.
We consider them separately because each type of flow results from different
activities and gives rise to different tax consequences.
A-8.
No. Depreciation is not a cash flow item. However, the tax shield which arises
from depreciation deductions for tax purposes is a cash flow item and is included.
A-9.
The total amount depreciated over the life of the machine (and, therefore, often
the tax savings associated with that depreciation) is the same regardless of the
depreciation method used. However, for capital investment decisions, the timing
of the savings is important because it affects the net present value of the
depreciation tax shield.
A-10.
Although the working capital might be assumed to be returned to the firm at the
end of the project, the firm does not have the use of those funds during that time.
Therefore, the present value of the working capital returned is less than the
present value of the working capital contributed.
,A-11.
The net present value analysis for a new plant considered in this appendix
considers the cash flows from the entire life of the plant and compares the
present value of those cash flows to the initial investment in the plant. Accounting
measures of income use a measure of plant cost (depreciation), which is an
allocation of the plant cost to the individual years. This allocation often does not
depend on the actual usage of the plant. Therefore, plants that are built with the
intention of growing output to future demand will have insufficient cash inflows in
the first year to cover the depreciation cost. Accounting income, therefore will be
low (or negative)..
, Solutions to Exercises
A-12. (20 min.) Present Value of Cash Flows: Star City.
a. At 20%
Time Year
0 1 2 3 4 5
Net cash flow............. ($200,000) $20,000 $50,000 $80,000 $80,000 $100,000
PV factor (20%) ......... 1.000 .833 .694 .579 .482 .402
Present values .......... ($200,000) $16,660 $34,700 $46,320 $38,560 $ 40,200
Net PV of project ....... ($ 23,560)
b. At 12%
Time Year
0 1 2 3 4 5
Net cash flow............. ($200,000) $20,000 $50,000 $80,000 $80,000 $100,000
PV factor (12%) ......... 1.000 .893 .797 .712 .636 .567
Present values .......... ($200,000) $17,860 $39,850 $56,960 $50,880 $ 56,700
Net PV of project ....... $ 22,250
