CHAPTER 5

Capital Investment

Capital Investment
Organizations often invest in long-term commitments like new production systems, plants,
equipment, and product development. Sound capital investment decisions require estimating
project cash flows.

Four financial models:

a. payback period
b. accounting rate of return
c. net present value
d. internal rate of return to evaluate the merits of a proposed project.

CAPITAL INVESTMENT DECISION

Capital investment decisions involve planning, setting goals, and selecting long-term assets.
They are crucial for managers as they place resources at risk and affect future firm
development. Poor decisions can be costly and should enhance profitability.

Capital budgeting is the process of making capital investment decisions.

The two types of capital budgeting project

a. independent projects which is accepting or rejecting one project doesn't affect the cash
flows of others (e.g., launching new product lines)
b. mutually exclusive projects, which is choosing one project automatically excludes
others (e.g., choosing between an automated or manual production system).

Capital investments are long-term assets that lose value over time. A successful investment
should recover its initial cost and provide a reasonable return. This return should be high
enough to compensate for the opportunity cost of the funds invested, meaning the return that
could have been earned by investing the money elsewhere. Since companies often use funds
from various sources with different opportunity costs, the required return on investment should
fall between the opportunity costs of those sources.

Managers need to establish clear goals and priorities for capital investments and develop
criteria for accepting or rejecting proposals. This chapter will explore four common methods
used for evaluating investments, including both non-discounting and discounting approaches.
These methods will be applied to independent and mutually exclusive projects.

PAYBACK PERIOD AND ACCOUNTING RATE OF RETURN: NON DISCOUNTING

METHODS

Capital investment decisions rely on two types of models: non discounting models that ignore
the time value of money, and discounting models that consider it. While non-discounting models
are often criticized, they remain in use. Discounting models have become more popular, and
many companies use both types to inform their decisions.

Payback Period

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One type of non discounting model. The payback period is the time required for a firm to recover
its original investment. When the cash flows of a project are assumed to be even, the following
formula can be used to compute the project's pay- back period:

Payback period = Original Investment / Annual Cash Flow

One approach to capital investment decisions involves setting a maximum payback period and
rejecting projects that exceed it. This method can serve as a rough risk measure, with longer
payback periods indicating higher risk. Companies with uncertain cash flows or liquidity issues
may prefer shorter payback periods. Industries prone to rapid obsolescence also favor quick
returns. However, there is a risk of managers prioritizing projects with fast payback to boost
short-term performance. Corporate budgeting policies and review committees can help mitigate
this incentive.

In summary, the payback period provides managers with information that can be used as
follows:

1. To help control the risks associated with the uncertainty of future cash flows
2. To help minimize the impact of an investment on a firm's liquidity problems
3. To help control the risk of obsolescence
4. To help control the effect of the investment on performance measures.

However, the method suffers significant deficiencies: it ignores a project's total profitability and
the time value of money. While the computation of the payback period may be useful to a
manager, to rely on it solely for capital investment decisions would be foolish.

ACCOUNTING RATE OF RETURN

The accounting rate of return (ARR) is the second commonly used non discounting model. The
accounting rate of return measures the return on a project in terms of income, as opposed to
using a project's cash flow. It is computed by the following formula:

Accounting rate of return= Average income/Original investment

Income is not equivalent to cash flows because of accruals and deferrals used in its
computation. The average income of a project is obtained by adding the income for each year of
the project and then dividing this total by the number of years. Average income is computed by
summing annual income over the life of the project and then dividing by the number of years of
the project. Annual income is approximated as annual cash flow less annual depreciation
expense. Average income for a project also can be approximated by subtracting average
depreciation from average cash flow. Assuming that all revenues earned in a period are
collected and that depreciation is the only non- cash expense, the approximation is exact.

Unlike the payback period, the accounting rate of return does consider a project's profitability;
like the payback period, it ignores the time value of money as illustrated in Cornerstone 5.2,
Question (3)]. Ignoring the time value of money is a critical deficiency and can lead a manager
to choose investments that do not maximize profits. It is because the payback period and the
accounting rate of return ignore the time value of money that they are referred to as non
discounting models. Discounting models use discounted cash flows, which are future cash flows
expressed in terms of their present value. The use of discounting models requires an
understanding of the present value concepts.

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THE NET PRESENT VALUE METHOD

Net present value (NPV) is one of two discounting models that explicitly considers the time
value of money and, therefore, incorporates the concept of discounting cash inflows and
outflows.
Net present value (NPV) is the difference in the present value of the cash inflow and outflows
associated with a project:

⎡ 𝑙 ⎤
NPV = ⎢∑ 𝐶𝐹𝑡/(𝑙 + 𝑖) − 𝑙⎥
⎢ ⎥
⎣ ⎦
⎡ ⎤
= ⎢∑ (𝐶𝐹1)(𝑑𝑓𝑡) ⎥ - l
⎢ ⎥
⎣ ⎦
=P-l

where:
l = the present value of the project’s cost (usually the initial outlay)
𝐶𝐹𝑡= The cash inflow to be received in period t with t = l
i = The required rate of return
n = The useful live of the project
t = The time period
P = The present value of the project’s future cash inflows
𝑙
𝑑𝑓1= 1/(1 + 𝑖) , the discount factor

Net present value measures the profitability of investment. If the NPV is positive, it measures
the increase in wealth. For a firm, this means that the size of a positive NPV measures the
increase in the value of the firm resulting from an investment.

To use the NPV method, a required rate of return must be defined. The required rate of return is
the minimum acceptable rate of return. It is also referred to as the discount rate or the hurdle
rate and should correspond to the cost of capital. The cost of capital is a weighted average of
the costs from various sources, where the weight is defined by the relative amount from each
source. In theory, the cost of capital is the correct discount rate, although, in practice, some
firms choose higher discount rates as a way to deal with the uncertain nature of future cash
flows. Yet the cost of capital should already embed uncertainty in its value and so using higher
discount rates may create an unhealthy bias. Thus, it will generally be assumed that the cost of
capital is the required part of return.

If the net present value is positive, it signals that

(1) the initial investment has been recovered,
(2) the required rate of return has been recovered, and
(3) a return in excess of (1) and (2) has been received.

Thus, if NPV is greater than zero, then the investment is profitable and therefore acceptable. It
also conveys the message that the value of the firm should increase because more than the
cost of capital is being earned. If NPV equals zero, then the decision maker will find acceptance
or rejection of the investment equal. Finally, if NPV is less than zero, then the investment should
be rejected. In this case, it is earning less than the required rate of return.

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INTERNAL RATE OF RETURN
The internal rate of return (IRR) is defined as the interest rate that sets the present value of a
project's cash inflows equal to the present value of the project's cost. In other words, it is the
interest rate that sets the project's NPV at zero. The following equation can be used to
determine a project's IRP:
𝑖
I = ∑ 𝐶𝐹𝑡/(1 + 𝑖)

Where:
t= l,... , n

The IRR (the interest rate, i, in the equation) can be found by setting 1=0. Once the IRR for a
project is computed, it is compared with the firm's required rate of return.

a. If the IRR > the required rate, the project is deemed acceptable
b. If the IRR is equal to the required rate of return, acceptance or rejection of the
investment is equal
c. If the IRR < the required rate of return, the project is rejected.
Solving for 1 to determine the IRR is a straightforward process when the annual cash flows are
uniform or even.

l = CF(df)
Solving for df, we obtain:

df = I /CF
= Investment/ Annual Cash Flow

The interest rate corresponding to this discount factor is the IRR. In this case, it is possible to
approximate the IRR by interpolation; however, for our purposes, we will simply identify the
range for the IRP as indicated by the table values.

To solve by trial and error, start by selecting a possible value for i. Given this first guess, the
present value of the future cash flow is computed and then compared to the initial investment. If
the present value is greater than the initial investment the interest rate is too low; if the present
value is less than the initial investment, the interest rate is too high.

NPV VERSUS IRR: MUTUALLY EXCLUSIVE PROJECTS

The focus is on independent projects, but the use of NPV analysis and IRR in comparing
mutually exclusive projects is intriguing. NPV is generally preferred over IRR when making
wealth-maximizing decisions in the presence of competing alternatives.

​
NPV Compared with IRR

NPV and IRR are two models that yield the same decision for independent projects. However,
for competing projects, they can produce different results. For mutually exclusive projects, the
project with the highest NPV or the highest IRR should be chosen. NPV differs from IRR in two
major ways: it assumes each cash inflow received is reinvested at the required rate of return,

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and it measures profitability in absolute terms, which is affected by the size of the investment. In
a conflict between the two methods, NPV produces the correct signal. For example, if a
manager is faced with choosing between two mutually exclusive investments, Project A has a
higher.

Computing after Taxation

Cash flow pattern determination is crucial in capital investment analysis, as errors can lead to
erroneous decisions. Two steps are needed: forecasting revenues, expenses, and capital
outlays, and adjusting these gross cash flows for inflation and tax effects. Forecasting cash
flows is technically demanding and requires judgment from managers. After-tax cash flows can
be calculated using tax law. Adjusting forecasted cash flows improves their accuracy and utility
in capital expenditure analysis.

Conversion of Gross Cash flows to after Tax Cash flows

To analyze gross cash flows accurately, analysts must adjust them for taxes.

Cash flows are broken into three categories:

a. initial cash outflows needed to acquire assets
b. operating cash flows produced over the project's life
c. final disposal cash flows.

Net cash outflows and inflows are adjusted for tax effects, which include provisions for
revenues, operating expenses, depreciation, and relevant tax implications. Net cash outflows in
Year 0 are the difference between the initial cost of the project and any cash inflows directly
associated with it. Under current tax law, all costs relating to asset acquisition must be
capitalized and written off over the asset's useful life. Principal tax implications at the point of
acquisition relate to recognition of gains and losses on the sale of existing assets and
investment tax revenues.

MACRS Depreciation

Personal property, except real estate, is classified into six classes for tax purposes. Each class
specifies the life of the assets for depreciation, with most equipment, machinery, office furniture,
light trucks, automobiles, computer equipment, and small tools classified as three-year assets.
Taxpayers can use the straight-line method or the modified accelerated cost recovery system
(MACRS) to compute annual depreciation. The half-year conversion applies, assuming a newly
acquired asset is in service for half of its first taxable year. If an asset is disposed of before its
class life, half of the depreciation is allowed for that year.

CAPITAL INVESTMENT: ADVANCED TECHNOLOGY AND ENVIRONMENTAL

CONSIDERATIONS

Long-term investments in advanced technology and pollution prevention (P2) technology can
provide a competitive advantage in the manufacturing environment. Investing in robots and
computer integrated manufacturing can improve quality, increase flexibility, and reduce lead
times, leading to increased customer satisfaction and market share. P2 opportunities involve
proactively targeting pollution causes, re-engineering complex products, and investing in new
technologies.

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Discounted cash flow analysis is crucial for capital investment decisions in advanced technology
or P2 opportunities, but its inputs vary from traditional approaches, including investment
definition, operating cash flow estimation, salvage value treatment, and discount rate selection.

How Investment Differs

Investment in automated manufacturing processes is much more complex than investment in
the standard manufacturing equipment of the past. For standard equipment, the direct costs of
acquisition represent virtually the entire investment. For automated manufacturing, the direct
cost can represent as little as 50 or 60 percent of total investment; software, engineering,
training and implementation are a significant percentage of the total cost.

How Estimates of Operating Cash Flow Differ

Estimates of operating cash flows from investments in standard equipment have typically relied
on directly identifiable tangible benefits, such as direct savings from labor, power, and scrap.
Similarly, environmental investment in end-of-pipe emissions control have relied on the direct
environmental cost savings (e.g. reductions in the costs of waste management and regulatory
compliances). In reality, many environmental costs are hidden within other costs. Some are
buried in overhead (e.g. the portion of maintenance cost attributable to maintaining equipment
associated with end-of-pipe emissions control).
Postaudi - a follow up analysis of a capital project once it is implemented. It compares the
actual benefits and costs with the estimated benefits and costs.

Salvage Value
Terminal or salvage value has often been ignored in investment decisions. The usual reason
offered is the difficulty in estimating it. Because of this uncertainty, the effect of salvage value
has often been ignored or heavily discounted. This approach may be unwise, however, because
salvage value could make the difference between investing or not investing.
Sensitivity Analysis - changes the assumptions on which the capital investment analysis relies
and assesses the effect on the cash flow pattern. It is often referred to as what-if analysis.

Discount Rates
Being overly conservative with discount rates can prove even more damaging. In theory, if future
cash flows are known with certainty, the correct discount rate is a firm’s cost of capital. In
practice, future cash flows are uncertain, and managers often choose a discount rate higher
than the cost of capital to deal with that uncertainty. If the rate chosen is excessively high, it will
bias the selection process toward short term investments.

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CORNERSTONE
Cornerstone 5.1

The HOW and WHY of Calculating the Payback Period

Information:
Suppose that a company is considering two different and mutually exclusive projects (A and B),
where both have a five year life and require an investment of $210,000. The cash flow pattern
for each project are given below.

Project A: Even cash flows of $70,000 per year

Project B: $120,000, $100,000, $90,000, $50,000, and $30,000:

Why:
The payback period is the time required to recover a project’s initial investment.
It may be useful to help assess such things as (1) the impact of an investment on liquidity, (2)
financial risk, and (3) obsolescence risk.

Required:
1. Calculate the payback period for Project A (even cash flows).
2. Calculate the payback period for project B (uneven cash flows). Which project should be
accepted based on payback analysis? Explain.
3. What if a third mutually exclusive project, Project C, became available with the same
investment and annual cash flows of $100,000? Now which project would be chosen?

Solution:
1. Even cash flows:
Payback period = Original investment/Annual cash flow
= $210,000/ $70,000
= 3.0 years

2. Uneven cash flows

Year Unrecovered Annual Cash Flow Time Needed for
Investment Payback
(Beginning Year)

1 $210,000 $120,000 1.0 year

2 $90,000 $100,000 0.9 vear

*At the beginning of the year, an additional $90,000 is needed to recover the investment. Since
a net cash flow of $100,000 is expected, only 0.9 year ($90,000/$100,000) needed to recover
the remaining $90,000, assuming a uniform cash flow throughout the year

Project B has a shorter payback period and thus seems less risky and would have less impact
on liquidity

3. The payback for Project C is 2.1 years ($210,000/$100,000). Project B still has the better
payback, but Project C promises more cash flow over its life and would have a more favorable
impact on liquidity.

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Cornerstone 5.2

The HOW and WHY of Calculating the Accounting Rate of Return

Information:
Assume that an investment requires an initial outlay of $300,000 with no salvage value. The life
of the investment is five years with the following yearly cash flows (in chronological sequence):
$90,000, $120,000, $90,000, and $150,000.

Why:
The accounting rate of return for a project is average income for the project dividend by the
original investment. The accounting rate of return thus considers the profitability of an
investment.

Required:
1. Calculate the annual net income for each of the five years.
2. Calculate the accounting rate of return.
3. What if a second competing project had the same initial outlay and salvage value but the
following cash flows (in chronological sequence) $150,000, $120,000, $90,000, $90,000, and
$90, 000. Using the accounting rate of return metric, which project should be selected. The first
or the second? Which project is really the better of the two?

Solution:
1. Yearly depreciation expense ($300,000 - $0)/5= $60,000
Year 1 net income= $90,000 - $60,000 = $30,000
Year 2 net income= $90,000- $60,000 = $30,000
Year 3 net income= $120,000- $60,000 = $60,000
Year 4 net income= $90,000 - $60,000 = $30,000
Year 5 net income= $150,000- $60,000 = $90,000

2. Total net income (five years) = $240,000

Average net income= $240,000/5 = $48,000
Accounting rate of return = $48,000/$300,000 = 0.16

3. The second project has an identical accounting rate of return; thus, the metric would say
there is no difference between the two projects. However, in reality, the second project would be
preferred even though it provides the same total cash because in returns larger amounts of
cash sooner than the first project

Cornerstone 5.3

The HOW and WHY of Analyzing NRV

Information:
Polson Company is considering production of a new cell phone with the following associated
data:

● Expected annual revenues: $750,000

● Projected product life cycle: five years

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 ● Equipment: $800,000 with a salvage value of $100,000 after five years
● Expected increase in working capital: $100,000 (recoverable at the end of five years)
● Annual cash operating expenses: estimated at $450,000
● Required rate of return: 12 percent

Why:
NPV is the present value of future cash flows less the initial outlay. All projects with a positive
(negative) NPV should be accepted (rejected), Present value of future cash flows is calculated
using the required rate of return (usually the cost of capital).

Required:
1. Estimate the annual cash flows for the cell-phone project.
2. Using the estimated annual cash flows, calculate the NPV.
3. What if revenues were overestimated by $150,000? Redo the NPV analysis, correcting for
this error. Assume the operating expenses remain the same.

Solution:

1.
Year Item Cash Flow

0 Equipment $(800,000)

Working capital (100,000)

Total $(900,000)

1-4 Revenues $750,000

Operating expense (450,000)

Total $300,000

5 Revenues $750,000

Operating expense (450,000)

Salvage 100,000

Recovery of working capital 100,000

Total $ 500,000

2.

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 Year Cash Flow Discount Factor* Present Value

0 $(900,000) 1.000 $(900,000)

1-4 300,000 3.037 911,100

5 500,000 0.567 283,500

Net present value $ 294,600

3. Correcting for the overestimation error of $150,000 would cause the project to be rejected, as
shown below:

Year Cash Flow Discount Factor* Present Value

0 $(900,000) 1.000 $(900,000)

1-4 150,000 3.037 455,550

5 350,000 0.567 198,450

Net present value $ (246,000)

Cornerstone 5.4

The HOW and WHY of Calculating the Internal Rate of Return

Information:
A firm with a cost of capital of 10 percent is considering two independent investments:
(1) A new computer-aided design system that costs $240,000 and will produce net cash flows
of $99,900 at the end of each year for the next three years
(2) An inventory management system that costs $50,000 and will produce labor savings of
$30,000 and $36,000 at the end of the first and second year, respectively.

Why:
The IRR is the interest rate where NPV = 0. The IRR is determined by solving Equation 5.2.
Acceptable investments should have an IRR greater than the cost of capital (or required rate of
return).

Required
1. Calculate the IRR for the first investment and determine if it is acceptable or not.
2. Calculate the IRR of the second investment and comment on its acceptability. Use 18 percent
as the first guess.
3. What if cash flows for the first investment are $102,000 instead of $99,900?

Solution:

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1. df = $240,000/ $99,900 = 2.402. Since the life of the investment is three years, we must find
the third row and move across this row until we encounter 2.402. The interest rate
corresponding to 2.402 is 12 percent, which is the IRR. Since IRR >0.10, the investment is
acceptable.

2. To find the IRR, we must find f by trial and error such that $50,000 = $30,000/ (1+i) +
2
$36,000/(𝑙 + 𝑖 ) . Using i = 0.18 as the first guess, yields discount factors of 0.847 and 0.713
and thus the following present value for the two cash inflows

P = (0.847 x $30 000) + (0.718 X $36,000)

= 25 410 + 25 848
= $51,258

Since P > $50,000, a higher interest rate is needed. Letting i = 20 percent, we obtain:

P= (0.833 x $30,000) + (0.694 x $36,000)

= 24 990 + 24 984
= $49,974

Since this value is reasonably close to $50,000, we can say that IRR = 20 percent.
Since IRR > 0.10, the investment is acceptable.

3. df = $240,000/$102,000 = 2.353. This discount factor now lies between 12 and 14 percent,
which means the IRR > 0.10

Cornerstone 5.5
The HOW and WHY of Determining NPV and IRR for Mutually Exclusive Projects

Information:
Milagro Travel Agency is considering two different computer systems: the Standard T2 System
and the Custom Travel System. The projected annual revenues, annual costs, capital outlays,
and project life for each system (in after-tax cash flows) are as follows:

Standard T2 Custom Travel

Annual revenues $240,000 $300,000

Annual operating cos(s 120,000 160,000

Systəm investment 360,000 420,000

Project life 5 years 5 years

Assume that the cost of capital for the company is 12 percent.

Why:
Choosing the project with the largest NPV is consistent with wealth maximization. Thus, NPV is
recommended for choosing among competing projects.

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Required:
1. Calculate the NPV for the Standard T2 System.
2. Calculate the NPV for the Custom Travel System. Which of the two computer systems should
be chosen?
3. What if the owner of the Milagro Travel Agency wants to know why IRR is not being used for
the investment analysis? Calculate the IRR for each project and explain why it is not suitable for
choosing among mutually exclusive investments.
Solution:
1.
Standard T2 System: NPV Analysis

Year Cash Flow Discount Factor Present Value

0 $(360,000) 1.000 $(360,000)

1-5 120,000 3.605 432,600

Net present value $72,600

2.
Custom Travel System: NPV Analysis

Year Cash Flow Discount Factor Present Value

0 $(420,000) 1.000 $(420,000)

1-5 140,000 3.605 504,700

Net present value $84,700

The Custom Travel System has the larger NPV and so would be chosen.

3. IRR Analysis:
Standard T2: Discount factor = Initial investment/Annual cash flow
= $360,000/$120,000
= 3.0

Custom Travel: Discount Factor = Initial investment/Annual cash flow

= $420,000/$140,000
= 3.0

df implies that IRR = 20 percent.

IRR is a relative measure of profits, and when comparing two competing projects it will not
reveal the absolute dollar contributions of the projects and thus will not necessarily lead to
choosing the project that maximizes wealth. The IRR is equal for the two computer systems, yet
the Custom Travel System is clearly superior as it increases the value of the firm more than the
other system.

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Cornerstone 5.6

The HOW and WHY of Calculating After Tax Cash Flows

Information:i
A company plans to make a new product that requires new equipment costing $1,600,000. Bɔth
the product and equipment have a life of four years. The equipment will be depreciated on a
straight-line basis, with no expected salvage value. The annual income statement for the
product is given below.

Revenues $1,200,000

Less: Cash operating expenses (500,000)

Depreciation (400,000)

Income before income taxes $ 300,000

Less: Income taxes (@40%) (120,000)

Net income $ 180,000

Why:
It is often convenient to calculate the after tax cash flows to each item on the income statement.
Adding the after-tax cash flows for each item yields the same results as the income approach.

Required:
1. Using the income approach, calculate the after-tax cash flows.
2. Using the decomposition approach, calculate the after-tax cash flows for each item of the
income statement and show that the total is the same as the income approach.
3. What if it is desirable to express the decomposition approach in a spreadsheet format for the
four years to facilitate the use of spreadsheet software packages? Express the decomposition
approach in a spreadsheet format with a column for each income item and a total column.

Solution:
1. CF = NI + NC = $180,000 + 400,000 = $580,000

2.
(1 - T) x Revenue = (1 - 0.40) x $1,200,000 $720,000

(1 - T) x Cash Expenses = (1 - 0.40) x $ (500,000) (300,000)

i x Depreciation = 0.40 x $400,000 160,000

Operating Cash Flows $580,000

3.

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 Year (1 − 𝑡)𝑅
2
− (1 − 𝑡)𝐶
𝑏
𝑡𝑁𝐶
𝑐 CF

1 $720,000 $ (300,000) $160,000 $580,000

2 720,000 (300,000) 160,000 580,000

3 720,000 (300,000) 160,000 580,000

4 720,000 (300,000) 160,000 580,000

R= Revenue
𝑏
𝐶 = Cash operating expenses.
𝑐
𝑁𝐶 = Non Cash operating Expense

CORNERSTONE EXERCISES
Cornerstone Exercise 5.1 Payback Period

Jan Booth is considering investing in either a storage facility or a car wash facility. Both projects
have a five-year life and require an investment of $360,000. The cash flow patterns for each
project are given below.

Storage facility: Even cash flows of $120,000 per year

Car wash: $112,500, $142,500, $60,000, $120,000, and $90,000

Required:
1. Calculate the payback period for the storage facility (even cash flows).
2. Calculate the payback period for the car wash facility (uneven cash flows). Which project
should be accepted based on payback analysis? Explain.
3. What if a third mutually exclusive project, a laundry facility, became available with the same
investment and annual cash flows of $150,000? Now which project would be chosen?

Cornerstone Exercise 5.2 Accounting Rate of Return

Wecare Clinic is planning on investing in some new echocardiogram equipment that will require
an initial outlay of $170,000. The system has an expected life of five years and no expected
salvage value. The investment is expected to produce the following net cash flows over its life:
$68,000, $68,000, $85,000, $85,000, and $102,000.

Required:
Calculate the annual net income for each of the five years.
2. Calculate the accounting rate of return.
3. What if a second competing revenue-producing investment has the same initial outlay and
salvage value but the following cash flows (in chronological sequence): $102,000, $102,000,
$102,000, $68,000, and $17,000? Using the accounting rate of return metric, which project
should be selected: the first or the second? Which project is really the better of the two?

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Cornerstone Exercises 5.3 Net Present Value

Carsen Sorensen, controller of Thayn Company , just received the following data associated
with production of a new product:

● Expected annual revenues: $750,000

● Projected product life cycle: five years
● Equipment: $800,000 with a salvage value of $100,000 after five years
● Expected increase in working capital: $100,000 (recoverable at the end of five years)
● Annual cash operating expenses: estimated at $450,000
● Required rate of return: 8%

Required:
1. Estimate the annual cash flows for the new product.
2. Using the estimated annual cash flows, calculate the NPV
3. What if revenues were overestimated by $150,000? Redo the NPV analysis, correcting
for this error. Assume the operating expenses remain the same.

Cornerstone Exercise 5.4 Internal Rate of Return

Manzer Enterprises is considering two independent investments:

A new automated materials handling system that costs $900,000 and will produce net cash
inflows of $300,000 at the end of each year for the next four years.
A computer-aided manufacturing system that costs $775,000 and will produce labor savings
of $400,000 and $500,000 at the end of the first year and second year, respectively.

Manzer has a cost capital of 8%.

Required:
1. Calculate the IRR for the first investment and determine if it is acceptable or not.
2. Calculate the IRR of the second investment and comment on its acceptability. Use 12%
as the first guess.
3. What if the cash flows for the first investment are $250,000 instead of $300,000?

Cornerstone Exercise 5.5 NPV Versus Internal Rate or Return

Keating Hospital is considering two different low-field MRI systems: the Clearlook System and
the Goodview System. The projected annual revenues, annual costs, capital outlays, and
project life for each system (in after-tax cash flows) are as follows:

Clearbook Goodview

Annual revenues $720,000 $900,000

Annual operating costs 445,000 655,000
System investment 900,000 800,000
Project life 5 years 5 years

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Assume that the cost of capital for the company is 8 percent.

Required:
1. Calculate the NPV for the Clearbook System.
2. Calculate the NPV for the Goodview System. Which MRI system would be chosen?
3. What if Keating Hospital wants to know why IRR is not being used for the investment
analysis? Calculate the IRR for each project and explain why it is not suitable for
choosing among mutually exclusive investments.

Cornerstone Exercise 5.6 After-Tax Cash Flows

Warren Company plans to open a new repair service center for one of its electronic products.
The center requires an investment in depreciable assets costing $480,000. The assets will be
depreciated on a straight-line basis, over four years, and have no expected salvage value. The
annual income statement for the center is given below.

Revenues $360,000
Less: Cash operating expenses (150,000)
Depreciation (120,000)
Income before income taxes $ 90,000
Less: Income Taxes (@40%) (36,000)
Net Income $ 54,000

Required:
1. Using the income approach, calculate the after-tax cash flows.
2. Using the decomposition approach, calculate the after-tax cash flows for each item of the
income statement and show that the total is the same as the income approach.
3. What if it is desirable to express the decomposition approach in a spreadsheet format
for the four years to facilitate the use of spreadsheet software packages? Express the
decomposition approach in a spreadsheet format, with a column for each income item
and a total column.

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