# Capital Budgeting Techniques

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Chapter 9 Capital Budgeting Techniques Â„ Solutions to Problems Note to instructor: In most problems involving the internal rate of return calculation, a financial calculator has been used. P9-1. LG 2: Payback Period Basic (a) \$42,000 Ã· \$7,000 = 6 years (b) The company should accept the project, since 6 < 8. P9-2. LG 2: Payback Comparisons Intermediate (a) Machine 1: \$14,000 Ã· \$3,000 = 4 years, 8 months Machine 2: \$21,000 Ã· \$4,000 = 5 years, 3 months (b) Only Machine 1 has a payback faster than 5 years and is acceptable. (c) The firm will accept the first machine because the payback period of 4 years, 8 months is less than the 5-year maximum payback required by Nova Products. (d) Machine 2 has returns which last 20 years while Machine 1 has only seven years of returns. Payback cannot consider this difference; it ignores all cash inflows beyond the payback period. 222 Part 3 Long-Term Investment Decisions P9-3. LG 2: Choosing Between Two Projects with Acceptable Payback Periods Intermediate (a) Project A Project B Year Cash Inflows Investment Balance Year Cash Inflows Investment Balance 0 âˆ’\$100,000 0 âˆ’\$100,000 1 \$10,000 âˆ’90,000 1 40,000 âˆ’60,000 2 20,000 âˆ’70,000 2 30,000 âˆ’30,000 3 30,000 âˆ’40,000 3 20,000 âˆ’10,000 4 40,000 0 4 10,000 0 5 20,000 5 20,000 Both project A and project B have payback periods of exactly 4 years. (b) Based on the minimum payback acceptance criteria of 4 years set by John Shell, both projects should be accepted. However, since they are mutually exclusive projects, John should accept project B. (c) Project B is preferred over A because the larger cash flows are in the early years of the project. The quicker cash inflows occur, the greater their value. P9-4. LG 3: NPV Basic PVn = PMT Ã— (PVIFA14%,20 yrs) NPV = PVn âˆ’ Initial investment (a) PVn = \$2,000 Ã— 6.623 NPV = \$13,246 âˆ’ \$10,000 PVn = \$13,246 NPV = \$3,246 Calculator solution: \$3,246.26 Accept (b) PVn = \$3,000 Ã— 6.623 NPV = \$19,869 âˆ’ \$25,000 PVn = \$19,869 NPV = âˆ’\$5,131 Calculator solution: âˆ’ \$5,130.61 Reject (c) PVn = \$5,000 Ã— 6.623 NPV = \$33,115 âˆ’ \$30,000 PVn = \$33,115 NPV = \$3,115 Calculator solution: \$3,115.65 Accept Chapter 9 Capital Budgeting Techniques 243 Calculation of Operating Cash Flows New Machine Year Reduction in Operating Costs Depreciation Net Profits Before Taxes Taxes Net Profits After Taxes Cash Flow 1 \$350,000 \$270,000 \$80,000 \$32,000 \$48,000 \$318,000 2 350,000 432,000 âˆ’82,000 âˆ’32,800 âˆ’49,200 382,800 3 350,000 256,500 93,500 37,400 56,100 312,600 4 350,000 162,000 188,000 75,200 112,800 274,800 5 350,000 162,000 188,000 75,200 112,800 274,800 6 0 67,500 âˆ’67,500 âˆ’27,000 âˆ’40,500 27,000 Existing Machine Year Depreciation Net Profits Before Taxes Taxes Net Profits After Taxes Cash Flow 1 \$152,000 âˆ’\$152,000 âˆ’\$60,800 \$91,200 \$60,800 2 96,000 âˆ’96,000 âˆ’38,400 âˆ’57,600 38,400 3 96,000 âˆ’96,000 âˆ’38,400 âˆ’57,600 38,400 4 40,000 âˆ’40,000 âˆ’16,000 âˆ’24,000 16,000 5 0 0 0 0 0 6 0 0 0 0 0 Incremental Operating Cash Flows ...

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