You are on page 1of 7

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.

b.

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.

b.

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
==========