Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 1 CAPITAL BUDGETING (CAPBUD) Practice Problem Solutions 1. Year Cash Outflow Cash Inflow Unrecovered Outflows 1 $15,000 $1,000 $14,000 2 8,000 2,000 20,000 3 2,500 17,500 4 4,000 13,500 5 5,000 8,500 6 6,000 2,500 ½ year 7 2,500 0 Payback period = 6 ½ years 2. Annual cost savings resulting from new machine = $18,000 ($30,000 cost per year to operate old machine - $12,000 cost per year to operate new machine) Depreciation of new machine = $120,000 ÷ 10 = $12,000 Accounting rate of return = ($18,000 - $12,000) ÷ ($120,000 - $40,000) Accounting rate of return = $6,000 ÷ $80,000 = 7.5%Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 2 3. (a) Payback period = $432,000 ÷ $90,000 = 4.8 years (b) Depreciation of machine = $432,000 ÷ 12 = $36,000 Accounting rate of return = ($90,000 - $36,000) ÷ $432,000 = 12.5% (c) Item Year(s) Amount of Cash Flow 10% Factor Present Value of Cash Flows Initial investment Now $(432,000) 1.0000 $(432,000) Annual net cash inflows 1 – 12 90,000 6.8137 613,233 Net present value $ 181,233 (d) The internal rate of return will be larger than the cost of capital (10%). Whenever the net present value is positive, the project generates a return (called the internal rate of return) that is larger than the cost of capital.Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 3 4. Project A Item Year(s) Amount of Cash Flow Tax Effect 20% Factor Present Value of Cash Flows Initial investment Now $(294,000) 1.00 1.0000 $(294,000) Annual net cash inflows 1 – 7 90,000 0.70 3.6046 227,090 Salvage value 7 20,000 0.70 0.2791 3,907 Depreciation 1 – 7 42,000 0.30 3.6046 45,418 Net present value $( 17,585) Project B Item Year(s) Amount of Cash Flow Tax Effect 20% Factor Present Value of Cash Flows Working capital needed Now $(294,000) 1.00 1.0000 $(294,000) Annual net cash inflows 1 – 7 84,000 0.70 3.6046 211,950 Release working capital 7 294,000 1.00 0.2791 82,055 Net present value $ 5 The $294,000 should be invested in Project B rather than Project A. Project B has a positive net present value, which means that it promises a return greater than 20% (albeit only very slightly larger than 20%). Project A is not acceptable at all, since it has a negative net present value. 5. Annual cost savings resulting from new machine = $21,000 ($40,000 cost using workers - $21,000 cost to operate cherry picking machine) IRR Factor = Initial Investment ÷ Annual Net Cash Inflows IRR Factor = $93,223 ÷ $21,000 = 4.4392 Look across the 12 period row in the present value of an annuity table until you find a factor of 4.4392. The IRR is equal to 20%. Elberta Fruit Farm should purchase the cherry picking machine since the IRR is greater than the cost of capital.Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 4 6. Item Year(s) Amount of Cash Flow Tax Effect 15% Factor Present Value of Cash Flows Initial investment Now $(100,000) 1.00 1.0000 $(100,000) Annual operator cost 1 – 10 ( 15,000) 0.70 5.0188 ( 52,697) Annual maintenance 1 – 10 ( 20,000) 0.70 5.0188 ( 70,263) Annual cost savings 1 – 10 60,000 0.70 5.0188 210,790 Salvage value 10 40,000 0.70 0.2472 6,922 Depreciation 1 – 10 10,000 0.30 5.0188 15,056 Net present value $ 9,808 Press Publishing Company should purchase the collating machine since the net present value is positive. This means the real return generated by the machine is greater than the minimum acceptable return (i.e., cost of capital). 7. Item Year(s) Amount of Cash Flow Tax Effect 15% Factor Present Value of Cash Flows Initial investment Now $(900,000) 1.00 1.0000 $(900,000) Working capital needed Now ( 60,000) 1.00 1.0000 ( 60,000) Annual cost savings 1 – 9 240,000 0.70 4.7716 801,629 Install pressure seals 5 ( 130,000) 0.70 0.4972 ( 45,245) Salvage value 9 45,000 0.70 0.2843 8,955 Release working capital 9 60,000 1.00 0.2843 17,058 Depreciation 1 – 9 100,000 0.30 4.7716 143,148 Net present value $ ( 34,455)Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 5 8. (a) IRR Factor = Initial Investment ÷ Annual Net Cash Inflows IRR Factor = $217,500 ÷ $30,000 = 7.2500 Look across the 18 period row in the present value of an annuity table until you find a factor of 7.2500. The IRR is equal to 12%. (b) ZZ News should not purchase the new auxiliary press since the IRR is less than the cost of capital. (c) IRR Factor at an IRR of 15% (from present value of annuity table) = 6.1280 6.1280 = $217,500 ÷ Annual inflows Annual inflows = $217,500 ÷ 6.1280 = $35,493 9. The lowest acceptable net present value is zero. Thus: Item Year(s) Amount of Cash Flow 20% Factor Present Value of Cash Flows Initial investment Now $(2,500,000) 1.0000 $(2,500,000) Annual net cash inflows 1 – 15 400,000 4.6755 1,870,200 Intangible benefits 1 – 15 X 4.6755 4.6755X Net present value 0 4.6755X + $1,870,200 - $2,500,000 = $0 4.6755X = $629,800 X = annual intangible benefits = $134,702Capital Budgeting (CAPBUD) – Practice Problem Solutions Pg 6 10. Sales ......................................................... 300,000 Ingredients ................................................ <60,000> (300,000 x 20%) Rent .......................................................... <42,000> Operating costs ......................................... <102,000> Commissions ............................................ <36,000> (300,000 x 12%) Depreciation ............................................. <16,800> [(270,000 - 18,000) ÷ 15] Net income ............................................... 43,200 (a) Accounting rate of return = 43,200 ÷ 270,000 = 16% Since the accounting rate of return exceeds the minimum rate of return of 12%, Sandy would acquire the franchise.