1. Capital Budgeting Techniques
Chapter IX Tutorial
Capital Budgeting Techniques

2. 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).

3. 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

4. Exercise Solution

5. 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.

6. Exercise 9 - 4 Solution Project T-Shirt PV = -15,000 N = 4 PMT = 8,000
Solve for I IRR = 39.08%

7. 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?

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

9. 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

10. Problem Solution

11. 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.

12. Problem Solution

13. 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?

14. Problem Solution

15. 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

16. Problem Solution

17. Problem 9 - 9 Solution cont.

18. 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?

19. Problem Solution

20. 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.

21. Problem Solution

22. Problem 9 - 21 Solution cont.