# Capital Budgeting Techniques

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Capital Budgeting Techniques
Chapter IX Tutorial Capital Budgeting Techniques

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).

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

Exercise Solution

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.

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

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?

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

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

Problem Solution

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.

Problem Solution

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?

Problem Solution

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

Problem Solution

Problem 9 - 9 Solution cont.

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?

Problem Solution

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.

Problem Solution

Problem 9 - 21 Solution cont.