Capital Budgeting Problem Examples

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# Capital Budgeting Problem Examples - PowerPoint PPT Presentation

## Capital Budgeting Problem Examples

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##### Presentation Transcript

1. Capital Budgeting Problem Examples Please click on the speaker icon on each slide to hear my explanation of how the problem can be solved.

2. Example One – A New Investment After the long drought of 1992, the manager of Long Branch Farm is considering the installation of an irrigation system. The system has an invoice price of \$100,000 and will cost an additional \$15,000 to install. It is estimated that it will increase revenues by \$20,000 annually, although operating expenses other than depreciation will also increase by \$5,000. The system will be depreciated straight-line over its depreciable life (5 years) to a zero salvage value. The system can actually be sold for an estimated \$25,000 at the end of 5 years. If the tax rate on ordinary income is 40 percent and the firm’s required rate of return is 16 percent. Should the firm purchase the new system?

3. Long Branch Farms - 2 CF0 -100,000 Cost of System -15,000 Cost of Installation -\$115,000 Initial Investment

4. Long Branch Farms - 3 CF1-5 Operating Cash Flows (20,000 – 5,000)(1-.40) + 23000(.40) = \$18,200

5. Long Branch Farms - 4 CF5T Terminal Cash Flows 25,000 Salvage Value -10,000 Tax on Gain \$15,000 NPV = -\$48,266 IRR = -2.43%

6. Example Two – A Replacement Problem International Soup Company is considering replacing a canning machine. The old machine is being depreciated by the straight-line method over a 10-year recovery period from a depreciable cost basis of \$120,000. The old machine has 5 years of remaining usable live, at which time its salvage value is expected to be zero, and it can be sold now for \$40,000. This machine has a current book value of \$60,000. The purchase price of the new machine is \$250,000 and it will have shipping and installation costs of \$12,500. It has a 5-year life and an expected salvage value of \$25,000. Annual savings of electricity, labor and materials from use of the new machine are estimated at \$40,000. The new machine will require an additional inventory of spare parts of \$30,000. The company is in a 40 percent tax bracket, and its cost of capital is 16 percent. The machine will be depreciated straight line over its five-year life. What should the firm do?

7. International Soup - 2 CF0 – Initial Cash Flow -\$250,000 Purchase Price of New -12,500 Installation +40,000 Sale of Old Equipment +8,000 Tax Effect of Sale -30,000 Working Capital -\$244,500 Initial Investment

8. International Soup - 3 CF1-5 Operating Cash Flows (40,000)(1-.40) + (40,500)(.40) = 24,000 + 16,200 = \$40,200

9. International Soup - 4 CF5T Terminal Cash Flow +25,000 Salvage Value of New Equipment -10,000 Tax Effect on Gain +30,000 Recoup Working Capital \$45,000 Terminal Cash Flow NPV = -\$91,448 IRR = 0.18%

10. Example Three – EAA / EAC Sony Corporation is considering the purchase of a new phone system for a sales office in Boise, Idaho. The Lucent Technologies system costs \$54,000, has annual operating expenses of \$4,000 and an expected life of 9 years. The Toshiba system has a cost of \$48,000, annual operating expenses of \$4,000 and an expected life of 7 years. Ignoring depreciation and taxes and assuming a cost of capital of 9 percent for such an investment, which system should Sony purchase? You are free to use either replacement chain or EAA/EAC analysis.

11. Lucent / Toshiba - 2 • Estimate the CF’s for each time period • Find the NPV of the CF’s at the appropriate discount rate – clear calculator. • Enter the NPV of the CF’s as PV, the life of the asset as N, and the discount rate as I. • Solve for PMT and that is the EAA / EAC.

12. Lucent / Toshiba - 3 Lucent: CF0 = -\$54,000 CF1-9 = -\$4,000 NPV = -\$77,981 EAA/EAC = -\$13,007 Toshiba: CF0 = -\$48,000 CF1-7 = -\$4,000 NPV = -\$68,132 EAA/EAC = -\$13,537

13. The End I hope this helped. Please don’t hesitate to call or email with any questions. Bruce