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Chapter IX Tutorial Capital Budgeting Techniques.

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Presentation on theme: "Chapter IX Tutorial Capital Budgeting Techniques."— Presentation transcript:

1 Chapter IX Tutorial Capital Budgeting Techniques

2 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 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 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 Solution Project T-Shirt PV = -15,000 N = 4 PMT = 8,000 Solve for IIRR = 39.08%

7 Problem 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. a)Determine the payback period for this project. b)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 Choosing between 2 projects with acceptable payback periods Each project requires $100,000 investment Maximum payback period 4 years a)Determine payback period of each project. b)Which one should they choose? c)Explain why is one of the projects a better choice. YearProject AProject B 1$10,000$40,000 2$20,000$30,000 3 $20,000 4$40,000$10,000 5$20,000

10 Problem Solution

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

12 Problem Solution

13 Problem 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 a)If Simes has cost of capital 9%, which form of payment would they choose? b)What yearly payment would make the two offers identical in value at a cost of capital of 9% c)Would your answer be different if the yearly payments were made at the beginning of each year? Show the difference. d)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 NPV- exclusive projects Hook industries is considering the replacement of a drill press Cost of capital is 15% a)Calculate NPV of each press. b)Evaluate acceptability. c)Rank the presses best to worst ABC Init. Inv.$85,00 0 $60, ,00 0 YearCash Inflows (CF t ) 1$18,00 0 $12,00 0 $50,00 0 2$18,00 0 $14,00 0 $30,00 0 3$18,00 0 $16,00 0 $20,00 0 4$18,00 0 $20,00 0 5$18,00 0 $20,00 0 6$18,00 0 $25,00 0 $30,00 0 7$18,00 0 $40,00 0 8$18,00 0 $50,00 0

16 Problem Solution

17 Problem Solution cont.

18 Problem 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. a)Determine IRR. Is it acceptable? b)Assuming cash inflows stay same how many additional years would the flows have to continue to make IRR 15%? c)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 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% MACRS a)Calculate initial investment. b)Determine incremental operating cash flows. c)Determine the terminal cash flow. d)Depict on a time line the relevant cash flows. YearPercentage 120% 232% 319% 412% 5 65%

21 Problem Solution

22 Problem Solution cont.


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