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**Capital Budgeting Techniques**

Chapter IX Tutorial Capital Budgeting Techniques

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**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).

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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

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Exercise Solution

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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.

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**Exercise 9 - 4 Solution Project T-Shirt PV = -15,000 N = 4 PMT = 8,000**

Solve for I IRR = 39.08%

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**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. Determine the payback period for this project. Should the company accept the project? Why?

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Problem Solution (a) $42,000 / $7,000 = 6 years (b) The company should accept the project, since 6 < 8.

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Problem 9 - 3 Choosing between 2 projects with acceptable payback periods Each project requires $100,000 investment Maximum payback period 4 years Determine payback period of each project. Which one should they choose? 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 4 5

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Problem Solution

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Problem 9 - 4 NPV Calculate the NPV for the following 20-year projects. Comment on the acceptability of each Opportunity cost is 14% Initial investment is $10,000; cash inflows are $2,000 per year.

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Problem Solution

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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 If Simes has cost of capital 9%, which form of payment would they choose? What yearly payment would make the two offers identical in value at a cost of capital of 9% Would your answer be different if the yearly payments were made at the beginning of each year? Show the difference. The after-tax cash inflows are projected to $250,000 per year for 15 years. Will this factor change the decision?

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Problem Solution

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**Problem 9 - 9 NPV- exclusive projects**

Hook industries is considering the replacement of a drill press Cost of capital is 15% Calculate NPV of each press. Evaluate acceptability. 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 $14,000 $30,000 3 $16,000 $20,000 4 5 6 $25,000 7 $40,000 8

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Problem Solution

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**Problem 9 - 9 Solution cont.**

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**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. Determine IRR. Is it acceptable? Assuming cash inflows stay same how many additional years would the flows have to continue to make IRR 15%? With given life, initial investment, and cost of capital what is the minimum annual cash inflow the firm should accept?

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Problem Solution

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**Problem 9 - 21 Integrative - Complete investment decision Existing New**

MACRS Year Percentage 1 20% 2 32% 3 19% 4 12% 5 6 5% 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% Calculate initial investment. Determine incremental operating cash flows. Determine the terminal cash flow. Depict on a time line the relevant cash flows.

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Problem Solution

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**Problem 9 - 21 Solution cont.**

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© Chia Fah Choy 2005 Topic 2 – Investment Appraisal: Background and Techniques.

© Chia Fah Choy 2005 Topic 2 – Investment Appraisal: Background and Techniques.

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