capital budgeting (cma part2-d)

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Dry Cleaner Example

A dry cleaner is looking to replace an old laundry machine with a bigger one.


The cost of new machine is $3000 and shipment cost is $200. This will reduced working capital by $500. The old machine can be sold for $1000 and generate $500 in profit. (Tax rate is 40%)


The new laundry machine will generate an additional $1400 a year and it will add additional cost of $200. The total cost of the new machine ($3200) will be depreciated over 4 years (Salvage value after 4 years will be $400). (Tax rate is 40%)


The new laundry machine can be sold after 4 years for $900 (Book value will be $400). This increase the working capital by $500 (Tax rate is 40%).


Required rate of return, Discount Rate or Cost of Capital is 8% over 4 years

P r e s e n t V a l u e A n n u i t y Ta b l e


P r e s e n t V a l u e Ta b l e o f a S i n g l e F u t u r e Amoun t

Required rate of return, Discount Rate or Cost of Capital is 8% over 4 years


P r e s e n t V a l u e A n n u i t y Ta b l e

9.5%


NPV IRR

Measure $ Amount % of return

Consider Time value of Money

Evaluate projects with different required rate of returns

Reinvestment rate Discount rate/ Required rate of

return IRR rate


Which project would you select?

Invest $1 Get $2 NPV = $1

Invest $100 Get $150 NPV = $50

The project with greatest NPV not largest IRR will add more value to the company


Simple Payback Method: -‐ Even cash flows:

-‐ Uneven cash flows:

Discounted Payback Method: Openthinkingacademy.com

Ignore Time Ignore cash flow Biased toward Value of Money beyond cutoff date Short-‐term Projects


120 (12%)

90 (9.2%)

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capital budgeting (cma part2-d)

Business