Chapter IXTutorial

Capital Budgeting Techniques

Capital Budgeting Techniques

• Calculate, interpret, and evaluate the payback period.

• Calculate, interpret, and evaluate the present value (NPV).

• Calculate, interpret, and evaluate the internal rate of return (IRR).

Exercise 9 - 3

• Project Kelvin will cost $45,000 and generate cash inflows of $20,000 per year for the next 3 years

• Project Thompson will cost $275,000 and generate cash inflows of $60,000 per year for 6 years.

• Using an 8% cost of capital, calculate each project’s NPV and make a recommendation based on your findings

Exercise 9 - 3 Solution

Exercise 9 - 4

• Calculate the IRR for each of the following projects and recommend best project.

• Project T-shirt requires initial investment of $15,000 and generates cash inflows of $8,000 per year for 4 years.

• Project Board Shorts requires an initial investment of $25,000 and produces cash inflows of $12,000 per year for 5 years.

Exercise 9 - 4 Solution

Project T-Shirt

• PV = -15,000

• N = 4

• PMT = 8,000

• Solve for I IRR = 39.08%

Problem 9 - 1

• Payback period

• Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax inflows of $7,000 per year for 10 years. The firm has maximum acceptable payback period of 8 years.

a) Determine the payback period for this project.

b) Should the company accept the project? Why?

Problem 9 - 1 Solution

(a) $42,000 / $7,000 = 6 years

(b) The company should accept the project, since 6 < 8.

Problem 9 - 3

• Choosing between 2 projects with acceptable payback periods

• Each project requires $100,000 investment

• Maximum payback period 4 years

a) Determine payback period of each project.

b) Which one should they choose?

c) Explain why is one of the projects a better choice.

Year Project A Project B

1 $10,000 $40,000

2 $20,000 $30,000

3 $30,000 $20,000

4 $40,000 $10,000

5 $20,000 $20,000

Problem 9 - 3 Solution

Problem 9 - 4

• NPV

• Calculate the NPV for the following 20-year projects. Comment on the acceptability of each

• Opportunity cost is 14%

a) Initial investment is $10,000; cash inflows are $2,000 per year.

b) Initial investment is $10,000; cash inflows are $2,000 per year.

c) Initial investment is $10,000; cash inflows are $2,000 per year.

Problem 9 - 4 Solution

Problem 9 - 7

• NPV

• Car inventor has offered Simes choice of either one time payment $1,500,000 today or a series of 5 year-end payments of $385,000

a) If Simes has cost of capital 9%, which form of payment would they choose?

b) What yearly payment would make the two offers identical in value at a cost of capital of 9%

c) Would your answer be different if the yearly payments were made at the beginning of each year? Show the difference.

d) The after-tax cash inflows are projected to $250,000 per year for 15 years. Will this factor change the decision?

Problem 9 - 7 Solution

Problem 9 - 9

• NPV- exclusive projects

• Hook industries is considering the replacement of a drill press

• Cost of capital is 15%

a) Calculate NPV of each press.

b) Evaluate acceptability.

c) Rank the presses best to worst

A B C

Init. Inv. $85,000

$60,000

130,000

Year Cash Inflows (CFt)

1 $18,000

$12,000

$50,000

2 $18,000

$14,000

$30,000

3 $18,000

$16,000

$20,000

4 $18,000

$18,000

$20,000

5 $18,000

$20,000

$20,000

6 $18,000

$25,000

$30,000

7 $18,000

$40,000

8 $18,000

$50,000

Problem 9 - 9 Solution

Problem 9 - 9 Solution cont.

Problem 9 - 13

• IRR, investment life and cash inflows

• Oak enterprises accepts projects earning more than 15%. Oak is considering a 10 year project that provides $10,000 annual cash inflows and requires $61,450 initial investment.

a) Determine IRR. Is it acceptable?

b) Assuming cash inflows stay same how many additional years would the flows have to continue to make IRR 15%?

c) With given life, initial investment, and cost of capital what is the minimum annual cash inflow the firm should accept?

Problem 9 - 13 Solution

Problem 9 - 21

• Integrative - Complete investment decision

• Existing– 10yrs ago at $1,000,000

– Sells $1,200,000

• New– Cost $2,200,000

– 5yrs, MACRS

– Sales $1,600,000 increase per year

– Costs 50% of Sales

• Cost of Capital 11%

• Tax 40%

MACRS

a) Calculate initial investment.b) Determine incremental operating

cash flows.c) Determine the terminal cash flow.d) Depict on a time line the relevant

cash flows.

Year Percentage

1 20%

2 32%

3 19%

4 12%

5 12%

6 5%

Problem 9 - 21 Solution

Problem 9 - 21 Solution cont.