Capital Budgeting Problem Examples

Please click on the speaker icon on each slide to hear my explanation of how the problem can be solved.

Example One – A New Investment

After the long drought of 1992, the manager of Long Branch Farm is considering the installation of an irrigation system. The system has an invoice price of $100,000 and will cost an additional $15,000 to install. It is estimated that it will increase revenues by $20,000 annually, although operating expenses other than depreciation will also increase by $5,000. The system will be depreciated straight-line over its depreciable life (5 years) to a zero salvage value. The system can actually be sold for an estimated $25,000 at the end of 5 years. If the tax rate on ordinary income is 40 percent and the firm’s required rate of return is 16 percent. Should the firm purchase the new system?

Long Branch Farms - 2

CF 0 -100,000 Cost of System -15,000 Cost of Installation -$115,000 Initial Investment

Long Branch Farms - 3

CF 1-5 Operating Cash Flows (20,000 – 5,000)(1-.40) + 23000(.40) = $18,200

Long Branch Farms - 4

CF 5T Terminal Cash Flows 25,000 -10,000 $15,000 Salvage Value Tax on Gain NPV = -$48,266 IRR = -2.43%

Example Two – A Replacement Problem

International Soup Company is considering replacing a canning machine. The old machine is being depreciated by the straight-line method over a 10-year recovery period from a depreciable cost basis of $120,000. The old machine has 5 years of remaining usable live, at which time its salvage value is expected to be zero, and it can be sold now for $40,000. This machine has a current book value of $60,000.

The purchase price of the new machine is $250,000 and it will have shipping and installation costs of $12,500. It has a 5-year life and an expected salvage value of $25,000. Annual savings of electricity, labor and materials from use of the new machine are estimated at $40,000. The new machine will require an additional inventory of spare parts of $30,000. The company is in a 40 percent tax bracket, and its cost of capital is 16 percent. The machine will be depreciated straight line over its five-year life. What should the firm do?

International Soup - 2

CF 0 – Initial Cash Flow -$250,000 -12,500 +40,000 +8,000 -30,000 -$244,500 Purchase Price of New Installation Sale of Old Equipment Tax Effect of Sale Working Capital Initial Investment

International Soup - 3

CF 1-5 Operating Cash Flows (40,000)(1-.40) + (40,500)(.40) = 24,000 + 16,200 = $40,200

International Soup - 4

CF 5T Terminal Cash Flow +25,000 Salvage Value of New Equipment -10,000 Tax Effect on Gain +30,000 Recoup Working Capital $45,000 Terminal Cash Flow NPV = -$91,448 IRR = 0.18%

Example Three – EAA / EAC

Sony Corporation is considering the purchase of a new phone system for a sales office in Boise, Idaho. The Lucent Technologies system costs $54,000, has annual operating expenses of $4,000 and an expected life of 9 years. The Toshiba system has a cost of $48,000, annual operating expenses of $4,000 and an expected life of 7 years. Ignoring depreciation and taxes and assuming a cost of capital of 9 percent for such an investment, which system should Sony purchase? You are free to use either replacement chain or EAA/EAC analysis.

Lucent / Toshiba - 2

 Estimate the CF’s for each time period  Find the NPV of the CF’s at the appropriate discount rate – clear calculator.

 Enter the NPV of the CF’s as PV, the life of the asset as N, and the discount rate as I.

 Solve for PMT and that is the EAA / EAC.

Lucent / Toshiba - 3

Lucent: CF 0 = -$54,000 CF 1-9 = -$4,000 NPV = -$77,981 EAA/EAC = -$13,007 Toshiba: CF0 = -$48,000 CF1-7 = -$4,000 NPV = -$68,132 EAA/EAC = -$13,537

The End

I hope this helped. Please don’t hesitate to call or email with any questions. Bruce