EX 1

FINC 340
Capital Budgeting Problem

You have been asked to evaluate a new machine being considered by the Santa Fe Railroad Co.
The machine will require a $16,000 investment now and will worth $3,000 after taxes at the
end of five years. The after-tax income is estimated to be $4,250 per year for five years.
After tax income includes the effect of depreciation.

a. Calculate the NPV for the machine assuming a 12 percent cost of capital.

b. Calculate the internal rate of return for the machine

Page 1
 EX 1 ans.

Example 1 Solution

0 1 2 3 4 5
Investment $ (16,000)
Project Income $ 4,250 $ 4,250 $ 4,250 $ 4,250 $ 4,250
Salvage Value $ 3,000
Cash Flows $ (16,000) $ 4,250 $ 4,250 $ 4,250 $ 4,250 $ 7,250

NPV @ .12 $1,023

IRR 14.36%

Page 2
 0 1 2 3 4 5 6
Invest. In -350000
aft. Tax cost savings 95700 95700 95700 95700 95700 95700
chg in NW -19500 19500
sale of machine 75000
tax on sale of machine -25500
DTS (=D x T) 23800 38080 22848 13708.8 13708.8 6854.4
Cash Flow -369500 119500 133780 118548 109408.8 109408.8 171554.4

NPV ( r = $104,635.23
IRR 24.78%

Annual Depr % 0.2 0.32 0.192 0.1152 0.1152 0.0576

Annual Depr $ (D) 70000 112000 67200 40320 40320 20160
#VALUE!

-4097127 416667 138889 347222 482253 602816

-18%

Err:523
 EX 2

FINC 340
Capital Budgeting Problem #2

Station WJXT is considering the replacement of its old, fully depreciated sound mixer. Two
new models are available. Mixer X costs $216,000, has a five-year expected life, and will
generate after-tax cash flow savings of $68,200 per year. Mixer Y costs $345,000, has a ten-year
expected life, and generates after tax cash flow savings of $83,400 per year. The cost of capital is
10 percent. Should WJXT replace the old mixer with mixer X or Y?

Page 5
 EX 2 ans.

Example 2 Solution

Model X:
0 1 2 3 4 5 6 7
Investment (216,000)
AT Savings 68,200 68,200 68,200 68,200 68,200
NCF: (216,000) 68,200 68,200 68,200 68,200 68,200
NPV@.10 $42,532

Model Y:
Investment (345,000)
AT Savings 83,400 83,400 83,400 83,400 83,400 83,400 83,400
NCF: (345,000) 83,400 83,400 83,400 83,400 83,400 83,400 83,400
NPV@.10 $167,457

Equivalent Annual Benefit: (Solve for the annual payment using each NPV)
Model X: $11,220
Model Y: $27,253

Page 6
 EX 2 ans.

8 9 10

83,400 83,400 83,400

83,400 83,400 83,400

Page 7
 EX 3

FINC 340
Capital Budgeting Problem

Cobra Golf Co.is considering a proposal to replace an existing casting machine for producing a new
line of low quality golf clubs. The machine is expected to have a four-year useful life and will be
depreciated according to 3-year MACRS (.25, .38, .37). The machine will cost the
company $100,000 plus freight and installation costs of $20,000. The machine will be fully
depreciated and will have an ending market value of $30,000. Expanding the product line will
increase inventories by $10,000, but costs will decrease by $50,000 per year. Assume a tax rate
of 40 percent and a cost of capital of 10 percent.

a. What are the annual cash flows?

b. Calculate the NPV and IRR.

Page 8
 EX 3 ans.

Example 3 Solution: Cobra

0 1 2 3 4
Investment in Equipment $ (120,000)
NWC investment $ (10,000) $
10,000
After-tax Savings $ 30,000 $ 30,000 $ 30,000 $
30,000
Depr. Tax Shield $ 12,000 $ 18,240 $ 17,760 0
Market Value $ 30,000
Tax on Gain $ (12,000)
Net Cash Flow $ (130,000) $ 42,000 $ 48,240 $ 47,760 $ 58,000

NPV @ .10: $23,547

IRR: 17.71%

0.25 $ 0.38 0.37

$ 30,000 $ 45,600 $ 44,400
12,000 18,240 17,760

Page 9
 EX 3 ans.

% Depr
$ Depr
DTS

Page 10
Finance 340
Capital Budgeting Problem #4

Granger Shipyards is considering replacing an 8-year old riveting machine with a new model that
will lower costs by $28,000 per year. The new machine costs $100,000 (installed) and is
expected to have a useful life of 10 years with a salvage value of $5,000. The new machine
will be depreciated (SL) to 10 percent of its current cost, and since it requires less inventory than
the old machine, it is expected to save $8,000 in working capital costs over the life of the project.
The old machine has been fully depreciated and has no salvage value, and it will cost $7,500 to
properly dispose of the old machine. As an alternative, a riveting contractor could be hired to
do this work at the same cost as the worn out machine.

Assuming a cost of capital of 12 percent and a tax rate of .40, should the company buy the
new machine?
w model that

entory than
the project.
Example 4 Solution

0 1 2 3 4 5 6 7 8 9 10
Equipment: (100,000)
WC savings: 8,000
After-tax savings: 16800 16800 16800 16800 16800 16800 16800 16800 16800 16800
Depr. tax shield: 3600 3600 3600 3600 3600 3600 3600 3600 3600 3600
return of WC: -8000
Salvage value: 5000
Tax shield of loss: 2000
Net Cash Flow (92,000) 20400 20400 20400 20400 20400 20400 20400 20400 20400 19400

NPV @ 12% $22,943

IRR 17.84%

(100,000)
8,000
16800 16800 16800 16800 16800 16800 16800 16800 16800 16800
3600 3600 3600 3600 3600 3600 3600 3600 3600 3600
-8000
5000
2000
(92,000) 20400 20400 20400 20400 20400 20400 20400 20400 20400 19400

$22,943
17.84%
Finance 340
Capital Budgeting Problem #5

Majestic Mining Co. (MMC) is negotiating for the purchase of a new piece of equipment for
their current operations. MMC wants to know the maximum price it should be willing to pay
for the equipment, i.e. at what price does the NPV of the investment equal zero. You are given
the following facts:
1. The new equipment would replace existing equipment with a market value of $20,000.
2. The cost of the new equipment will be expensed immediately, not capitalized. MMC expects
to sell the equipment for $5,000 at the end of the project.
3. The new equipment will reduce before tax operating costs by $10,000 per year for 8 years.
4. The old equipment is now five years old. It is expected to last for another eight years and
will have no resale value. It was purchased for $40,000 and is being depreciated to zero
using the SL method over 10 years.
5. The tax rate for MMC is 34% and the discount rate is 8%.
Example 5 Solution

0 1 2 3 4 5 6 7 8
Sale of old equipment: 20,000
Lost Depr. TS: (1,360) (1,360) (1,360) (1,360) (1,360)
Cost savings: 6,600 6,600 6,600 6,600 6,600 6,600 6,600 6,600
Salvage of new equip: 5,000
Tax on salvage: (1,700)
20,000 5,240 5,240 5,240 5,240 5,240 6,600 6,600 9,900

PV @8% 54,281

The cost of the equipment must be equal to the present value of the expected cash flows plus the depreciation
tax shield at t = 0. If we let the cost of the equipment be X, the DTS will equal .34X. Therefore, the net cost
of the equipment is .66X. We solve for X by dividing the PV of cash flows, 54,281 / .66 = 82,243
Finance 340
Capital Budgeting Problem #6

A transportation company is considering the replacement of several trucks to reduce down-time,

thus providing better on-time delivery service. The existing trucks were purchased three years
ago for $75,000 and are being depreciated (SL) over their 8-year life to a book value of 15,000.
They could be sold today for $35,000. New trucks would cost $100,000, have a five-year
life, and be depreciated for tax purposes to a $20,000 book value, also using SL depreciation.
The company forecasts that the new trucks would reduce operating costs by $5,000 per year;
in addition, increased customer satisfaction would add $20,000 per year to cash revenues.
As long as the new trucks are around, the company must increase its inventory of spare parts
which would cost $2,500. At the end of five years, the new trucks would be sold for $25,000.
The appropriate discount rate is 12 percent and the firm is in the 35% tax bracket. Should they
invest in the new trucks? Old trucks could be sold in year 5 for 15,000.
Example 6 Solution
0 1 2 3 4 5
Cost of new trucks: (100,000)
Salvage of new fleet: 25,000
Tax on gain of sale: (1,750)
Sale of old fleet: 35,000
Tax benefit from sale: 6,125
Lost sale of old fleet: (15,000)
Additional WC: (2,500)
Depr. tax shield (new): 5,600 5,600 5,600 5,600 5,600
Lost Depr. TS: (2,625) (2,625) (2,625) (2,625) (2,625)
After-tax savings: 16,250 16,250 16,250 16,250 16,250
Recovery of WC: 2,500
(61,375) 19,225 19,225 19,225 19,225 29,975

NPV @ .12 14,027

IRR 20.3%

Depreciation on New Trucks: (100,000 - 20,000)/5 = 16,000 per year

Depr. on Old Trucks: (75,000 - 15,000)/8 = 7,500 per year
Boogie Music Co. operates a mid-sized recording studio in downtown Seattle. The stud
of $1,100,000 per year which are expected to remain constant over the next 10 years. T
like to upgrade the equipment with state-of-the-art technology. The cost of the new equ
all existing equipment is $1,000,000. The old equipment has a book value of $150,000
rate of $15,000 per year. The market value of the old equipment is also $150,000. The
depreciated over its 10-year life using the straight-line method to a book value of $200,
the new equipment would sell for $250,000 at the end of year 10. Improved technolog
lure in several new musicians in the area who also like to ski and sail, hence revenues a
$225,000 in the first year of operation and $320,000 in each of the remaining 9 years. A
increase from the current level of $400,000 to $550,000, while additional net working c
the time of installation.The marginal tax rate for Boogie Music is 34 percent, and the re
percent. Should the company invest in the new equipment? Use Excel spreadsheet.

The marginal tax rate for Boogie Music is 34 percent, and the relevant discount rate is 1
invest in the new equipment? Use Excel spreadsheet.
$300,000.00

$200,000.00

$100,000.00

X
$0.00 Y
0 0.1 0.2 0.3 0.4 0.5 0.6

($100,000.00)

($200,000.00)

($300,000.00)
 1 2 3 9 10

10,000
148,500 211,200 211,200 211,200 211,200
(99,000) (99,000) (99,000) (99,000) (99,000)
27,200 27,200 27,200 27,200 27,200
250,000
(17,000)

(5,100) (5,100) (5,100) (5,100) (5,100)

71,600 134,300 134,300 134,300 377,300

r% X Y
0 $100,000.00 $260,000.00
X Y Y-X 0.02 $83,782.64 $214,892.18
0 $ (150,000) $ (400,000) $ (250,000) 0.04 $69,013.50 $174,011.92
1 $ 20,000 $ 60,000 $ 40,000 0.06 $55,534.18 $136,878.14
2 $ 35,000 $ 90,000 $ 55,000 0.08 $43,206.48 $103,073.09
3 $ 60,000 $ 90,000 $ 30,000 0.1 $31,909.46 $72,233.02
4 $ 95,000 $ 240,000 $ 145,000 0.12 $21,537.04 $44,040.27
5 $ 40,000 $ 180,000 $ 140,000 0.14 $11,995.89 $18,216.72
r = 7% 0.16 $3,203.72 ($5,481.80)
NPV $49,234.31 $119,583.42 0.18 ($4,912.23) ($27,270.18)
IRR 16.77% 15.52% 14.81% 0.2 ($12,416.41) ($47,337.96)
PI 1.3282 1.2990 0.22 ($19,366.08) ($65,852.79)
0.24 ($25,812.18) ($82,963.21)
0.26 ($31,800.18) ($98,801.19)
0.28 ($37,370.68) ($113,484.15)
0.3 ($42,560.05) ($127,116.86)
0.32 ($47,400.95) ($139,792.92)
0.34 ($51,922.69) ($151,596.14)
0.36 ($56,151.71) ($162,601.72)
0.38 ($60,111.83) ($172,877.23)
0.4 ($63,824.60) ($182,483.49)
0.42 ($67,309.49) ($191,475.36)
0.44 ($70,584.19) ($199,902.40)
0.46 ($73,664.73) ($207,809.44)
0.48 ($76,565.71) ($215,237.09)
0.5 ($79,300.41) ($222,222.22)

$300,000.00

$200,000.00
$300,000.00

$200,000.00

$100,000.00

X
$0.00 Y
0 0.1 0.2 0.3 0.4 0.5 0.6

($100,000.00)

($200,000.00)

($300,000.00)
 Always
gives
correct
decision
works with with Benchmark
uncoventional mutually is it CF uses NOT
Rank CFs? exclusive? based? TVM? arbitrary?
1 NPV Yes Yes Yes Yes Yes
3 IRR No No Yes Yes Yes
5 Payback Yes No Yes No No
4 Disc Pay Yes No Yes Yes No
2 PI Yes No Yes Yes Yes
6 AAR Yes No No No No
 0 1 2 3 4
New Machine $ (350,000)
After tax savings $ 95,700 $ 95,700 $ 95,700 $ 95,700
change NWC $ (19,500)
DTS $ 23,800 $ 38,080 $ 22,848 $ 13,709
Salvage
Tax on Salvage
CF $ (369,500) $ 119,500 $ 133,780 $ 118,548 $ 109,409

NPV $68,181
IRR 22.19%

Depr % 20.00% 32.00% 19.20% 11.52%

Ann Depr 70000 112000 67200 40320
BV 280000 168000 100800 60480
 5 6

$ 95,700
$ 19,500
$ 13,709
$ 75,000
$ (18,646)
$ 185,263

11.52% 0.0576
40320 20160
20160 0
sale price 700 8560000 sale new clubs
fixed cost 8000000 13200000 lost sale exp clubs
variable cost 340 6000000 gain sale cheap clubs
# of sets 46000 1360000 before tax rev

lost sale 12000

price of lost sales 1100
incr sales 20000
price of cheap 300

0 1 2 3 4 5 6 7
equip 16100000
chg. NWC -900000 900000
DTS 920000 920000 920000 920000 920000 920000 920000
aft tax rev 816000 816000 816000 816000 816000 816000 816000