Shapiro: Chapter 2: Capital-Budgeting Principles and Techniques
1. a. What is the relationship between accounting income and economic profit?
Answer: Accounting income is calculated by taking revenues and subtracting all cash and non-cash expenses (such as depreciation). Accounting income also often recognizes losses for tax purposes as well, even though the economic loss may have taken place at another time. Economic profit is the sum of the present values of all the cash flows net of expenses generated by the firm’s actions. Economic profit measures true increments to value, but is hard to measure. Accounting profit is correlated with economic profit, but not ...view middle of the document...
Answer: At a 20 percent profit margin, the auto company will earn an annuity of about $3,000 every three years for the next 30 years. Discounted at 9 percent, this annuity is worth $9,402, assuming that the first new car is purchased three years from today. Hence, an investment to keep customers satisfied will have a positive NPV as long as the amount spent is less than $9,402. Thus, a car company should be willing to spend up to $9,402 in present value terms to keep its customers satisfied. A trick is available to calculate the present value of this annuity. Recognize that an annuity received every three years for 30 years and discounted at 9 percent is equivalent to a 10-year annuity discounted at 29.5029 percent since each cash flow term is discounted at (1.09)3 = 1.295029.
4. Demonstrate that the following project has internal rates of return of 0 percent, 100 percent, and 200 percent.
|Year |1 |2 |3 |4 |
|Cash flow |–$1,200 |+7,200 |–13,200 |+7,200 |
Answer: To demonstrate that an IRR calculation is valid, compute the net present value at the IRR. A valid IRR yields NPV = 0.
|Year |Cash Flow |PV@0% |PV@100% |PV@200% |
|1 |-1,200 |-1,200 |-600 |-400.00 |
|2 |+7,200 |+7,200 |+1,800 |+800.00 |
|3 |-13,200 |-13,200 |-1,650 |-488.89 |
|4 |+7,200 |+7,200 |+450 |+88.89 |
|Total |0 |0 |0 |0 |
5. During 1990, Dow Chemical generated the following returns on investment in its different business units:
|Business Unit |Return on Investment (%) |
|Plastics |16.6 |
|Chemicals/Performance Products |16.7 |
|Consumer Specialties |12.7 |
|Hydrocarbons/Energy |5.2 |
|Other |1.6 |
|Dow Chemical overall |11.8 |
Given these returns, which of the business units should Dow invest additional capital in? What additional information would you need in order to make that decision?