ACG 2071 – Take Home Problem SOLUTION DRAFT
Problem 1. Gill’s Towing Service is considering the purchase of an additional tow truck with a cost of
$65,000. Gill estimates the tow truck could be sold for $15,000 at the end of its 4-year estimated life.
Gill has a required rate of return of 6.2% and a cost of capital of 4.1%. This purchase would allow Gill
to tow 1,200 more per vehicles per year at $55 each. Gill would have to hire one additional driver with
a salary of $32,000 per year. Maintenance, fuel and insurance operating costs for the truck would be
$14,000 per year. The income tax rate is 30%. Gill uses straight line depreciation.
Calculate each of the following. Interpret the outcome of each capital budgeting method.
A.
B.
C.
D.
E.
Incremental annual operating cash flows
IRR
NPV
ARR
Payback period
Incremental revenue (1,200*$55)
Incremental driver
Maintenance, fuel, insurance
Depreciation (($65,000 - $15,000)/4)
Income before taxes
Income taxes expense
Net income
Add depreciation
Operating cash flows
CF0
C01
C02
C03
C04
17750
17750
17750
32750
$ 66,000
(32,000
(14,000)
(12,500)
7,500
(2,250)
5,250
12,500
$ 17,750
`
(65000)
IRR = 10.97%
The investment will generate around 11% cash return each year.
NPV = $8,017
The investment will generate a cash return that exceeds the company’s minimum required return of 6.2% each year.
ARR = $5,250 / [(65,000 + 15,000) / 2] = 13.13%
The investment will generate around a 13% return on profit each year.
PBP = $65,000/$17,750 = 3.66 years
The entire cash investment will be recovered in 3.66 years.
Problem 2. Cutler Cleaners wants to purchase of a new dry cleaning machine with a cost of $48,800.
The company has a cost of capital of 4.3% and a required rate of return of 6.4%. Its income tax rate is
32%. The acquisition is proposed for January 1, 2010. Cutler expects it can sell the dry cleaner for
$10,000 at end of its useful life of 4 years. Amounts estimated by Cutler estimates the following
incremental amounts to be generated by the machine:
Year 1
Year 2
Net income
$10,200 $8,600
Operating cash flows
19,900 18,300
Perform calculations for each of the capital budgeting methods.
CF0
C01
C02
C03
C04
19,900
18,300
18,800
28,500
Year 3
$9,100
18,800
`
(48800)
IRR = 25.14%
NPV = $23,912.31
ARR = [($10,200 + $8,600 + $9,100 + $8,800)/4] / [($48,800 + $10,000) / 2] = 31.21%
PBP =
To recover
Year 1
Year 2
Balance to collect year 3
Year 3: $10,600/$18,800
PBP = 2.56 years
$48,800
(19,900)
(18,300)
$10,600
0.56
Year 4
$8,800
18,500