Tutorial Sheet # 8 Suggested Solutions Unit 8: Capital Budgeting 1.

The payback period for each project is: A: 3 + ($185,000/$430,000) = 3.43 years B: 2 + ($7,000/$17,000) = 2.41 years The payback criterion implies accepting project B, because it pays back sooner than project A. b. The discounted payback for each project is: A: $25,000/1.15 + $70,000/1.152 + $70,000/1.153 = $120,695.32 $430,000/1.154 = $245,853.90 Discounted payback = 3 + ($350,000 120,695.32)/$245,853.90 = 3.93 years B: $17,000/1.15 + $11,000/1.152 + $17,000/1.153 = $34,277.96 $11,000/1.154 = $6,289.29 Discounted payback = 3 + ($35,000 34,277.96)/$6,289.29 = 3.11 years The discounted payback criterion implies accepting project B because it pays back sooner than A c. The NPV for each project is: A: NPV = $350,000 + $25,000/1.15 + $70,000/1.152 + $70,000/1.153 + $430,000/1.154 NPV = $16,549.22 B: NPV = $35,000 + $17,000/1.15 + $11,000/1.152 + $17,000/1.153 + $11,000/1.154 NPV = $5,567.25 NPV criterion implies we accept project A because project A has a higher NPV than project B. d. The IRR for each project is: A: $350,000 = $25,000/(1+IRR) + $70,000/(1+IRR)2 + $70,000/(1+IRR)3 + $430,000/(1+IRR)4 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.57% B: $35,000 = $17,000/(1+IRR) + $11,000/(1+IRR)2 + $17,000/(1+IRR)3 + $11,000/(1+IRR)4 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 23.05% IRR decision rule implies we accept project B because IRR for B is greater than IRR for A. e. The profitability index for each project is: A: PI = ($25,000/1.15 + $70,000/1.152 + $70,000/1.153 + $430,000/1.154) / $350,000 = 1.047 B: PI = ($17,000/1.15 + $11,000/1.152 + $17,000/1.153 + $11,000/1.154) / $35,000 = 1.159 Profitability index criterion implies accept project B because its PI is greater than project As. f. In this instance, the NPV criteria implies that you should accept project A, while profitability index, payback period, discounted payback and IRR imply that you should accept project B. The final decision should be based on the NPV since it does not have the ranking problem associated with the other capital budgeting techniques. Therefore, you should accept project A.

2.

The equation for the NPV of the project is: NPV = $27,000,000 + $46,000,000/1.1 $6,000,000/1.12 = $9,859,504.13 The NPV is greater than 0, so we would accept the project. b. The equation for the IRR of the project is: 0 = $27,000,000 + $46,000,000/(1+IRR) $6,000,000/(1+IRR)2 From Descartes rule of signs, we know there are two IRRs since the cash flows change signs twice. From trial and error, the two IRRs are: IRR = 56.14%, 85.77% When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are correct, that is, both interest rates make the NPV of the project equal to zero. If we are evaluating whether or not to accept this project, we would not want to use the IRR to make our decision.

3.

First we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation = $440,000/5 Annual depreciation = $88,000 Now, we calculate the after tax salvage value. The after-tax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so: After-tax salvage value = MV + (BV MV)tc Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the equation for the after tax salvage value becomes: After-tax salvage value = MV + (0 MV)tc After-tax salvage value = MV(1 tc) We will use this equation to find the after tax salvage value since we know the book value is zero. So, the after tax salvage value is: After tax salvage value = $60,000(1 0.34) After tax salvage value = $39,600 Using the tax shield approach, we find the OCF for the project is: OCF = $130,000(1 0.34) + 0.34($88,000) OCF = $115,720 Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the after-tax salvage value. NPV = $440,000 34,000 + $115,720(PVIFA10%,5) + [($39,600 + 34,000) / 1.15]

4.

First, we need to find the future value of the cash flows for the one year in which they are blocked by the government. So, reinvesting each cash inflow for one year, we find: Year 2 cash flow = $165,000(1.04) = $171,600 Year 3 cash flow = $190,000(1.04) = $197,600 Year 4 cash flow = $205,000(1.04) = $213,200 Year 5 cash flow = $183,000(1.04) = $190,320 So, the NPV of the project is: NPV = $450,000 + $171,600/1.112 + $197,600/1.113 + $213,200/1.114 + $190,320/1.115 NPV = $87,144.93 And the IRR of the project is: 0 = $450,000 + $171,600/(1 + IRR)2 + $197,600/(1 + IRR)3 + $213,200/(1 + IRR)4 + $190,320/(1 + IRR)5

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.95%
5. Investment: Initial Additional 2,000 / (1.12)

($15,000) ($1,594)

Working capital [2,000 + 200 + 300

(1.12)1 (1.12)

($2,418) $ (19,012)

Net working capital (2,000 +200+300) = 2,500 / (1.12) Increase in net revenues: (1 0.25) [6,000 / 1.12 + 6,500 / (1.12)2 + 7,500 / (1.12)3] 0.75[5,357.14 + 5,181.76 + 5,338.35] Salvage: Equipment 6,000 1 [0.20 (0.25)(2.12) 2(0.12 + 0.20) (1.12)

1,779

11,908

(1.12)

4,270 [ 1 (0.106 / 0.7168) ] Tax shields: Equipment: [15,000 (0.25) (0.20) (2.12) / 2(0.12 + 0.20) (1.12)] 1,590 / 0.7168

3,639

2,218

Net present value Since the NPV is positive, the project should be accepted.

$ 532

b) Since there is typically no standard against which to judge a projects PBP, it is difficult to decide when a project is acceptable. However, the PBP method can be used to compare projects, with the project with the shortest payback period selected. For the internal rate of return (IRR) method, a project is selected if its IRR exceeds the projects riskadjusted discount rate (RAD).