Capital Investment Decisions: An Overview (Solutions to Review Questions)

Capital Investment Decisions: An Overview Solutions to Review Questions REVIEW QUESTIONS A-1.What are the two most important factors an accountant must estimate in the capital investment decision? 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.What does the time value of money mean? 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.What is the difference between revenues and cash inflows? 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.What is the difference between expenses and cash outflows? 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.What is the difference between depreciation and the tax shield on depreciation? 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. CRITICAL ANALYSIS AND DISCUSSION QUESTIONS A-6.Given two projects with equal cash flows but different timing, how can we determine which (if either) project should be selected for investment? 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.What are the four types of cash flows related to a capital investment project and why do we consider them separately? 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.Is depreciation included in the computation of net present value? Explain. 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 tax deduction for depreciation is the same over the life of the project regardless of depreciation method. Why then would one be concerned about the depreciation method for capital investment analysis?” Comment. 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.“Working capital is just the temporary use of money during the life of the project. What is initially contributed is returned at the end, so it can be ignored in evaluating a project.” Comment. 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.In Chapter 14, we discussed performance measurement in investment centers, where the managers have decision authority over asset usage (for example, adding new plants). The financial performance measures discussed in Chapter 14 (ROI, residual income, and EVA) were based on accounting income, which measures plant cost by depreciation. Why is it possible that a project to build a new plant can have a negative residual income in the first year, but have a positive net present value? 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).