How should governments report their capital projects and debt service activities in their government-wide statements?

Ch 6. Questions for Review and Discussion

6. How should governments report their capital projects and debt service activities in their government-wide statements?

Click here for the solution: How should governments report their capital projects and debt service activities in their government-wide statements?

Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals

Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals. The amount of proposed investment, estimated income from operations, and net cash flow for each proposal are as follows:

Investments Year Income from Net cash operations flow

Proposal A: $425,000 1 $ 40,000 $125,000
2 40,000 125,000
3 40,000 125,000
4 15,000 100,000
5 (35,000) 50,000
------------- -------------
$100,000 $525,000
-------------- -------------
Proposal B: $610,000 1 $ 158,000 $280,000
2 158,000 280,000
3 78,000 200,000
4 28,000 150,000
5 (22,000) 100,000
----------------- -------------
$400,000 $1,010,000
--------------- ---------------
Proposal C: $275,000 1 $45,000 $ 100,000
2 45,000 100,000
3 45,000 100,000
4 45,000 100,000
5 35,000 90,000
----------- -------------
$215,000 $490,000
------------ -------------

Investment Year Income From Net Cash
operations Flow

Proposal D: $190,000 1 $22,000 $60,000
2 22,000 60,000
3 22,000 60,000
4 2,000 40,000
5 2,000 40,000
---------- -------------
$70,000 $260,000

The company’s capital rationing policy requires a maximum cash payback period of three years. In addition, a minimum average rate of return of 12% is required on all projects. If the preceding standards are met, the net present value method and present value indexes are used to rank the remaining proposals.

Present Value of $1 at Compound Interest

Year 6% 10% 12% 15% 20%
1 0.943 0.909 0.893 0.870 0.833
2 0.890 0.826 0.797 0.756 0.694
3 0.840 0.751 0.712 0.658 0.579
4 0.792 0.683 0.636 0.572 0.482
5 0.747 0.621 0.567 0.497 0.402
6 0.705 0.564 0.507 0.432 0.335
7 0.665 0.513 0.452 0.376 0.279
8 0.627 0.467 0.404 0.327 0.233
9 0.592 0.424 0.361 0.284 0.194
10 0.558 0.386 0.322 0.247 0.162

2. Giving effect to straight-line depreciation on the investments and assuming no estimated residual value, compute the average rate of return for each of the four proposals. Round to 1 decimal place.

Average rate of return
Proposal A:_______________%
Proposal B:_______________%
Proposal C:_______________%
Proposal D:_______________%

5.Compute the present value index for each of the proposals in (4). Round to 2 decimal places.

Select proposal to compute Present value index. __A or B___ __ C or D___
Present value index (rounded): ___________ ___________

Click here for the solution: Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals

Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals

Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals. The amount of proposed investment, estimated income from operations, and net cash flow for each proposal are as follows:

Investments Year Income from Net cash operations flow

Proposal A: $425,000 1 $ 40,000 $125,000
2 40,000 125,000
3 40,000 125,000
4 15,000 100,000
5 (35,000) 50,000
------------- -------------
$100,000 $525,000
-------------- -------------
Proposal B: $610,000 1 $ 158,000 $280,000
2 158,000 280,000
3 78,000 200,000
4 28,000 150,000
5 (22,000) 100,000
----------------- -------------
$400,000 $1,010,000
--------------- ---------------
Proposal C: $275,000 1 $45,000 $ 100,000
2 45,000 100,000
3 45,000 100,000
4 45,000 100,000
5 35,000 90,000
----------- -------------
$215,000 $490,000
------------ -------------

Investment Year Income From Net Cash
operations Flow

Proposal D: $190,000 1 $22,000 $60,000
2 22,000 60,000
3 22,000 60,000
4 2,000 40,000
5 2,000 40,000
---------- -------------
$70,000 $260,000

The company’s capital rationing policy requires a maximum cash payback period of three years. In addition, a minimum average rate of return of 12% is required on all projects. If the preceding standards are met, the net present value method and present value indexes are used to rank the remaining proposals.

Present Value of $1 at Compound Interest

Year 6% 10% 12% 15% 20%
1 0.943 0.909 0.893 0.870 0.833
2 0.890 0.826 0.797 0.756 0.694
3 0.840 0.751 0.712 0.658 0.579
4 0.792 0.683 0.636 0.572 0.482
5 0.747 0.621 0.567 0.497 0.402
6 0.705 0.564 0.507 0.432 0.335
7 0.665 0.513 0.452 0.376 0.279
8 0.627 0.467 0.404 0.327 0.233
9 0.592 0.424 0.361 0.284 0.194
10 0.558 0.386 0.322 0.247 0.162

2. Giving effect to straight-line depreciation on the investments and assuming no estimated residual value, compute the average rate of return for each of the four proposals. Round to 1 decimal place.

Average rate of return
Proposal A:_______________%
Proposal B:_______________%
Proposal C:_______________%
Proposal D:_______________%

5.Compute the present value index for each of the proposals in (4). Round to 2 decimal places.

Select proposal to compute Present value index. __A or B___ __ C or D___
Present value index (rounded): ___________ ___________

Click here for the solution: Grant Communications Inc. is considering allocating a limited amount of capital investment funds among four proposals

The following data are accumulated by Eco-Labs, Inc. in evaluating two competing capital investment proposals

EX 10-1 The following data are accumulated by Eco-Labs, Inc. in evaluating two competing capital investment proposals:

Testing Equipment Vehicle
Amount of investment $80,000 $28,000
Useful life 6 years 8 years
Estimated residual value 0 0
Estimated total income over the useful life $13,200 $14,000

Determine the expected average rate of return for each proposal. Round to one decimal place.

Click here for the solution: The following data are accumulated by Eco-Labs, Inc. in evaluating two competing capital investment proposals

Summer Company is considering three capital expenditure projects

E12-5 Summer Company is considering three capital expenditure projects. Relevant data for the projects are as follows.

Project Investment Annual Income Life of Project
22A $240,000 $15,000 6 years
23A 270,000 24,400 9 years
24A 280,000 21,000 7 years

Annual income is constant over the life of the project. Each project is expected to have zero salvage value at the end of the project. Summer Company uses the straight-line method of depreciation.

Instructions
(a) Determine the internal rate of return for each project. Round the internal rate of return factor to three decimals.
(b) If Summer Company's required rate of return is 11%, which projects are acceptable?


Click here for the solution: Summer Company is considering three capital expenditure projects

Morgan Company is considering a capital investment of $180,000 in additional productive facilities

E12-8 Morgan Company is considering a capital investment of $180,000 in additional productive facilities. The new machinery is expected to have a useful life of 6 years with no salvage value. Depreciation is by the straight-line method. During the life of the investment, annual net income and net annual cash flows are expected to be $20,000 and $50,000 respectively. Morgan has a 15% cost of capital rate which is the required rate of return on the investment.

Instructions
(a) Compute (1) the cash payback period and (2) the annual rate of return on the proposed capital expenditure.
(b) Using the discounted cash flow technique, compute the net present value.


Click here for the solution: Morgan Company is considering a capital investment of $180,000 in additional productive facilities

(Evaluating McGraw Industries Capital Structure) McGraw Industries, an established producer of printing equipment, expects its sales to remain flat

McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.

In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm’s capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.
Capital structure*

Source of capital Current (10% debt) A (30% debt) B (50% debt)
Long-term debt $1,000,000 $3,000,000 $5,000,000
Coupon interest rate** 9% 10% 12%
Common stock 100,000 shares 70,000 shares 40,000 shares
Required return on equity*** 12% 13% 18%

*These structures are based on maintaining the firm’s current level of $10,000,000 of total financing.
**Interest rate applicable to all debt.
***Market-based return for the given level of risk.

Lewis expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.


Click here for the solution: (Evaluating McGraw Industries Capital Structure) McGraw Industries, an established producer of printing equipment, expects its sales to remain flat

What are the advantages and disadvantages associated with the unadjusted rate of return method for evaluating capital investments

21. What are the advantages and disadvantages associated with the unadjusted rate of return method for evaluating capital investments?


Click here for the solution: What are the advantages and disadvantages associated with the unadjusted rate of return method for evaluating capital investments

Which is the best capital investment evaluation technique for ranking investment opportunities?

5. Which is the best capital investment evaluation technique for ranking investment opportunities?


Click here for the solution: Which is the best capital investment evaluation technique for ranking investment opportunities?

Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating

B2. (Choosing financial targets) Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating. Sanderson has identified six comparable firms and calculated the credit statistics shown here.

a. Sanderson’s return on assets is 5.3%. It has a total capitalization of $600 million. What are reasonable targets for long-term debt/cap, funds from operations/LT debt, and fixed charge coverage?

b. Are there any firms among the six who are particularly good or bad comparable? Explain.
c. Suppose Sanderson’s current ratio of long-term debt to total cap is 60% but its fixed charge coverage is 3.00. What would you recommend?

FIRM A B C D E F
Senior debt rating Baa2/BBB Baa3/BBB− Baa2/BBB Baa1/A− Baa1/BBB− Baa2/BBB+
Return on assets 5.2% 5.0% 5.4% 5.7% 5.2% 5.3%
Long-term debt/cap 38% 41% 45% 40% 25% 43%
Total cap ($MM) 425 575 525 650 210 375
Funds from operations/LT debt 39% 43% 28% 46% 57% 43%
Fixed charge cov 2.57 2.83 2.75 2.38 3.59 2.15


Click here for the solution: Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating

The following totals were drawn from Independence City’s “Schedule of Changes in Capital Assets by Function and Activity”

P. 7-4 Governments sometimes add to, but do not delete, their capital assets.

The following totals were drawn from Independence City’s “Schedule of Changes in Capital Assets by Function and Activity,” included in the city’s financial statements for the year ending June 30, 2012:

General capital assets, July, 1, 2011 $33,276,151
Additions/transfers-in 459,430
Deletions/transfers-out (265,795)
General capital assets, June 30, 2012 $33,469,786

The complete schedule disaggregates the data by function (e.g., general government, public safety, public works, health and welfare, culture, and recreation) and subfunction (e.g., park maintenance, recreation, tourism). Another schedule, “Schedule of General Capital Assets by Source,” shows the beginning and ending balances of the specific types of assets:

Type of Asset 2012 2011
Land $ 8,209,380 $ 8,209,380
Buildings $ 9,293,847 $ 9,292,611
Improvements other $ 1,088,307 $ 1,088,307
than buildings
Office furniture and $ 4,863,535 $ 4,536,506
equipment
Mobile equipment $ 7,834,277 $ 8,073,945
Other equipment $ 2,180,440 $ 2,075,402
Total $ 33,469,786 $ 33,276,151

1. Assume that the assets, excluding land, had an average useful life of 20 years. What percentage of the total assets, excluding land, would you expect to have been retired each year?

2. What percentage of the assets (beginning of year values). Excluding land, were actually retired during 2012 (assuming that all deletions/transfers out represent retirements?

3. What was the average useful life of the assets as implied by this percentage?

4. Assume that the entire $265,795 of the deletions and transfers-out applied to the mobile equipment. What would have been the useful life of the equipment as suggested by the percentage of the equipment retired?


Click here for the solution: The following totals were drawn from Independence City’s “Schedule of Changes in Capital Assets by Function and Activity”

Mountain Mist Inc.’s cost of capital is 11 percent

Mountain Mist Inc.’s cost of capital is 11 percent. In 2010, one of the firm’s divisions generated an EVA of $1,130,000. The fair market value of the capital investment in that division was $29,500,000. How much after-tax income was generated by the division in 2010?


Click here for the solution: Mountain Mist Inc.’s cost of capital is 11 percent

F. Calvert and G. Powers have capital balances on January 1 of $50,000 and $40,000, respectively

E12-4 F. Calvert and G. Powers have capital balances on January 1 of $50,000 and $40,000, respectively. The partnership income-sharing agreement provides for (1) annual salaries of $20,000 for Calvert and $12,000 for Powers, (2) interest at 10% on beginning capital balances, and (3) remaining income or loss to be shared 60% by Calvert and 40% by Powers.

Instructions
(a) Prepare a schedule showing the distribution of net income, assuming net income is (1) $50,000 and (2) $36,000.
(b) Journalize the allocation of net income in each of the situations above.


Click here for the solution: F. Calvert and G. Powers have capital balances on January 1 of $50,000 and $40,000, respectively

For its 2010 tax year, Ilex Corporation has ordinary income of $240,000, a short-term capital loss of $60,000, and a long-term capital gain of $20,000

For its 2010 tax year, Ilex Corporation has ordinary income of $240,000, a short-term capital loss of $60,000, and a long-term capital gain of $20,000. Calculate Ilex Corporation's tax liability for 2010.


Click here for the solution: For its 2010 tax year, Ilex Corporation has ordinary income of $240,000, a short-term capital loss of $60,000, and a long-term capital gain of $20,000

Longchamps Electric is faced with a capital budget of $150,000 for the coming year

Longchamps Electric is faced with a capital budget of $150,000 for the coming year. It is considering six investment projects and has a cost of capital of 7%. The six projects are listed in the following table, along with their initial investments and their IRRs. Using the data given, prepare an investment opportunities schedule (IOS). Which projects does the IOS suggest be funded? Does this group of projects maximize NPV? Explain.

Project Initial Investment IRR
1 $75,000 8%
2 40,000 10%
3 35,000 7%
4 50,000 11%
5 45,000 9%
6 20,000 6%


Click here for the solution: Longchamps Electric is faced with a capital budget of $150,000 for the coming year

Let’s assume that you have been asked to calculate risk-based capital ratios for a bank with the following accounts

10. Let’s assume that you have been asked to calculate risk-based capital ratios for a bank with the following accounts:

Cash = $5 million
Government securities = $7 million
Mortgage loans = $30 million
Other loans = $50 million
Fixed assets = $10 million
Intangible assets = $4 million
Loan-loss reserves = $5 million
Owners’ equity = $5 million
Trust-preferred securities = $3 million

Cash assets and government securities are not considered risky. Loans secured by real estate have a 50 percent weighting factor. All other loans have a 100 percent weighting factor in terms of riskiness.

a. Calculate the equity capital ratio.
b. Calculate the Tier 1 Ratio using risk-adjusted assets.
c. Calculate the Total Capital (Tier 1 plus Tier 2) Ratio using risk-adjusted assets.

Click here for the solution: Let’s assume that you have been asked to calculate risk-based capital ratios for a bank with the following accounts

Valley Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed capital budget of $4.5 million

Valley Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed capital budget of $4.5 million. The firm recognizes that any unused portion of this budget will learn than its 15% cost of capital, thereby resulting in a present value of inflows that is less than the initial investment. The firm has summarized, in the following table, the key data to be used in selecting the best group projects.

Project Initial Investment IRR Present Value of inflows at 15%
A $5,000,000 17% $5,400,000
B 800,000 18 1,100,000
C 2,000,000 19 2,300,000
D 1,500,000 16 1,600,000
E 800,000 22 900,000
F 2,500,000 23 3,000,000
G 1,200,000 20 1,300,000

a. Use the internal rate of return (IRR) approach to select the best group of projects.
b. Use the net present value (NPV) approach to select the best group of projects.
c. Compare, contrast, and discuss your findings in parts a and b.
d. Which projects should the firm implement? Why?

Click here for the solution: Valley Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed capital budget of $4.5 million

Swift Corp., a capital goods manufacturing business that started on January 4, 2010, and operates on a calendar-year basis

E18-15 (Installment-Sales Method and Cost-Recovery Method) Swift Corp., a capital goods manufacturing business that started on January 4, 2010, and operates on a calendar-year basis, uses the installment sales method of profit recognition in accounting for all its sales. The following data were taken from the 2010 and 2011 records.

2010 2011
Installment sales $480,000 $620,000
Gross profit as a percent of costs 25% 28%
Cash collections on sales of 2010 $130,000 $240,000
Cash collections on sales of 2011 –0– $160,000

The amounts given for cash collections exclude amounts collected for interest charges.

Instructions
(a) Compute the amount of realized gross profit to be recognized on the 2011 income statement, prepared using the installment-sales method.
(b) State where the balance of Deferred Gross Profit would be reported on the financial statements for 2011.
(c) Compute the amount of realized gross profit to be recognized on the income statement, prepared using the cost-recovery method.

Click here for the solution: Swift Corp., a capital goods manufacturing business that started on January 4, 2010, and operates on a calendar-year basis

In 2008, Adrianna contributed land with a basis of $16,000 and a fair market value of $25,000 to the A&I Partnership in exchange for a 25% interest in capital and profits

In 2008, Adrianna contributed land with a basis of $16,000 and a fair market value of $25,000 to the A&I Partnership in exchange for a 25% interest in capital and profits. In 2011, the partnership distributes this property to Isabel, also a 25% partner, in a no liquidating distribution. The fair market value has increased to $30,000 at the time the property is distributed. Isabel’s and Adrianna’s bases in their partnership interests are each $40,000 at the time of the distribution.

a. How much gain or loss, if any, does Adrianna recognize on the distribution to Isabel? What is Adrianna’s basis in her partnership interest following the distribution?
b. What is Isabel’s basis in the land she received in the distribution?
c. How much gain or loss, if any, does Isabel recognize on the distribution? What is Isabel’s basis in her partnership interest following the distribution?
d. How much gain or loss would Isabel recognize if she later sells the land for its $30,000 fair market value? Is this result equitable?
e. Would your answers to (a) and (b) change if Adrianna originally contributed the property to the partnership in 2000?

Click here for the solution: In 2008, Adrianna contributed land with a basis of $16,000 and a fair market value of $25,000 to the A&I Partnership in exchange for a 25% interest in capital and profits

Colorado Coal Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure

Colorado Coal Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure.

debt ratio pretax cost cost of equity weighted average
[B/(B+E)] of debt cost of capital

0.00 12.00
0.15 13.00 11.68
0.30 8.00 14.50
0.45 16.50 11.775
14.00 19.00 12.64

The company’s income tax rate is 40 percent.

a. Fill in the missing entries in the table.
b. Determine the capital structure (i.e., debt ratio) that minimizes the firm’s weighted average cost of capital


Click here for the solution: Colorado Coal Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure