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Published byYosef Bainum Modified over 2 years ago

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

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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 firms required rate of return is 16 percent. Should the firm purchase the new system?

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Long Branch Farms - 2 CF 0 -100,000 Cost of System -15,000 Cost of Installation -15,000 Cost of Installation -$115,000 Initial Investment

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

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

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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?

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International Soup - 2 CF 0 – Initial Cash Flow -$250,000 Purchase Price of New -12,500Installation -12,500Installation +40,000Sale of Old Equipment +40,000Sale of Old Equipment +8,000 Tax Effect of Sale +8,000 Tax Effect of Sale -30,000Working Capital -30,000Working Capital -$244,500Initial Investment

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

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International Soup - 4 CF 5T Terminal Cash Flow +25,000Salvage Value of New Equipment -10,000Tax Effect on Gain +30,000Recoup Working Capital $45,000Terminal Cash Flow NPV = -$91,448IRR = 0.18%

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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.

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

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Lucent / Toshiba - 3 Lucent: CF 0 = -$54,000 CF 1-9 = -$4,000 NPV = -$77,981EAA/EAC = -$13,007 Toshiba:CF0 = -$48,000 CF1-7 = -$4,000 NPV = -$68,132EAA/EAC = -$13,537

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The End I hope this helped. Please dont hesitate to call or email with any questions. Bruce

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