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CHAPTER 7: CAPITAL BUDGETING

DECISIONSPART I
Problems
1. An investment opportunity costing $180,000 is expected to yield net cash flows of
$60,000 annually for five years.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment.
c. Find the IRR on the investment.
SOLUTION:
a. NPV: $36,300 [(3.605 x $60,000) - $180,000]
b. Payback period: 3 years ($180,000/$60,000)
c. IRR: between 18 % and 20% (3.0 is between 3.127 and 2.991)
2. Tofte is considering the purchase of a machine. Data are as follows:
Cost
Useful life
Annual straight-line depreciation
Expected annual savings in cash
operation costs

$100,000
10 years
$ 10,000
$ 18,000

Tofte's cutoff rate is 12% and its tax rate is 40%.


a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.
SOLUTION:
a. Annual net cash flows: $14,800 [$18,000 pretax - 40% x ($18,000 - $10,000
depreciation)]

b. NPV: Negative $16,380 [($14,800 x 5.650) - $100,000]


3. Willow Company is considering the purchase of a machine with the following
characteristics.
Cost
Estimated useful life
Expected annual cash cost savings

$150,000
10 years
$35,000

Marquette's tax rate is 40%, its cost of capital is 12%, and it will use straight-line
depreciation for the new machine.
a. Compute the annual after-tax cash flows for this project.
b. Find the payback period for this project.
SOLUTION:
a. Annual cash flows: $27,000 [$35,000 - 40% x ($35,000 - $15,000)]
b. Payback period: 5.56 years ($150,000/$27,000)
4. Bilt-Rite Co. has the opportunity to introduce a new product. Bilt-Rite expects the
product to sell for $60 and to have per-unit variable costs of $40 and annual cash
fixed costs of $3,000,000. Expected annual sales volume is 250,000 units. The
equipment needed to bring out the new product costs $5,000,000, has a four-year
life and no salvage value, and would be depreciated on a straight-line basis. BiltRite's cost of capital is 10% and its income tax rate is 40%.
a. Find the increase in annual after-tax cash flows for this opportunity.
b. Find the payback period on this project.
c. Find the NPV for this project.
SOLUTION:
a. Increase in annual cash flows: $1,700,000
Income before taxes, 250,000 x ($60 - $40)
- $3,000,000 - $5,000,000/4
Income tax

750,000
(300,000)

---------$ 450,000
1,250,000
---------$1,700,000

Net income
Plus depreciation
Net cash flow
==========
b. Payback period: 2.94 years ($5,000,000/$1,700,000)
c. NPV: $389,000 [($1,700,000 x 3.170) - $5,000,000]

5. An investment opportunity costing $600,000 is expected to yield net cash flows of


$120,000 annually for ten years.
a. Find the NPV of the investment at a cutoff rate of 12%.
b. Find the payback period of the investment.
c. Find the IRR on the investment.
SOLUTION:
a. NPV: $78,000 [(5.650 x $120,000) - $600,000]
b. Payback period: 5 years ($600,000/$120,000)
c. IRR: 15% (5.0 is about halfway between 5.216 and 4.833)
6. Scottso has an investment opportunity costing $300,000 that is expected to yield the
following cash flows over the next six years:
Year
Year
Year
Year
Year
Year

One
Two
Three
Four
Five
Six

$75,000
$90,000
$115,000
$130,000
$100,000
$90,000

a.

Find the payback period of the investment.

b.

Find the book rate of return of the investment.

c.

Find the NPV of the investment at a cutoff rate of 10%.

SOLUTION:
a. Payback period: 3.15 years (75,000 + 90,000 + 115,000 + .15 x 130,000)
b. Book rate of return: 33.3%
Average return: $100,000 ($600,000 total / 6 years)
Depreciation:
50,000 ($30,000 / 6 years)
------Average income $50,000
Average investment: $300,000 / 2 = $150,000
Book rate of return = $50,000 / 150,000 = 33.3%
c. NPV: $130,530

1
2
3
4
5
6

Cash
-----75,000
90,000
115,000
130,000
100,000
90,000

Investment
NPV

Factor
-----.909
.826
.751
.683
.621
.564

PV
-----68,175
74,340
86,365
88,790
62,100
50,760
------430,530
300,000
------130,530
======

7. Acme is considering the purchase of a machine. Data are as follows:


Cost
Useful life
Annual straight-line depreciation
Expected annual savings in cash
operation costs

$160,000
10 years
$ ???
$ 33,000

Acme's cutoff rate is 12% and its tax rate is 40%.


a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.

c. Compute the IRR of the project.


SOLUTION:
a. Annual net cash flows: $26,200 [$33,000 pretax - 40% x ($33,000 - $16,000
depreciation)]
b. NPV: Negative $11,970 [($26,200 x 5.650) - $160,000]
c. IRR: between 10% and 12% [factor of 6.107 (160,000/26,200) is between 6.145
and 5.650]
8. Scottso has an investment opportunity costing $180,000 that is expected to yield the
following cash flows over the next five years:
Year One
Year Two
Year Three
Year Four
Year Five

$ 30,000
$ 60,000
$ 90,000
$ 60,000
$ 30,000

a.

Find the payback period of the investment.

b.

Find the book rate of return of the investment.

c.

Find the NPV of the investment at a cutoff rate of 12%.

SOLUTION:
a. Payback period: 3.0 years (30,000 + 60,000 + 90,000)
b. Book rate of return: 20%
Average return: $54,000 ($270,000 total / 5 years)
Depreciation: 36,000 ($180,000 / 5 years)
-----Average income $18,000
Average investment: $180,000 / 2 = $90,000
Book rate of return = $18,000 / $90,000 = 20%

c. NPV: $6,930

1
2
3
4
5

Cash
-----30,000
60,000
90,000
60,000
30,000

Investment
NPV

Factor
-----.893
.797
.712
.636
.567

PV
-----26,790
47,820
64,080
38,160
17,010
------193,860
180,000
------13,860
======

9. Reno Company is considering the purchase of a machine with the following


characteristics.
Cost
$160,000
Estimated useful life
5 years
Expected annual cash cost savings $56,000
Expected salvage value
none
Reno's tax rate is 40%, its cost of capital is 12%, and it will use straight-line
depreciation for the new machine.
a. Compute the annual after-tax cash flows for this project.
b. Find the payback period for this project.
c. Compute the NPV for this project.
SOLUTION:
a. Annual cash flows: $46,400 [$56,000 - 40% x ($56,000 - 32,000)]
b. Payback period: 3.45 years ($160,000/$46,400)
c. NPV: $7,272 [($46,400 x 3.605) - $160,000]
10. Whitehall Co. has the opportunity to introduce a new product. Whitehall expects the
project to sell for $40 and to have per-unit variable costs of $27 and annual cash

fixed costs of $1,500,000. Expected annual sales volume is 200,000 units. The
equipment needed to bring out the new product costs $3,500,000, has a four-year
life and no salvage value, and would be depreciated on a straight-line basis.
Whitehall's cutoff rate is 10% and its income tax rate is 40%.
a. Find the increase in annual after-tax cash flows for this opportunity.
b. Find the payback period on this project.
c. Find the NPV for this project.
SOLUTION:
a. Increase in annual cash flows: $1,100,000
Income before taxes, [200,000 x ($40 - $27)
- $1,500,000 - $3,500,000/4]
Income tax
Net income
Plus depreciation
Net cash flow
b. Payback period: 3.47 years ($3,500,000/$1,010,000)
c. NPV: negative $298,300 [($1,010,000 x 3.170) - $3,500,000]

225,000
( 90,000)
---------$ 135,000
875,000
---------$1,010,000
==========