Chapter IX
Tutorial
Capital Budgeting
Techniques
Capital Budgeting Techniques
• Calculate, interpret, and evaluate the
payback period.
• Calculate, interpret, and evaluate the
present value (NPV).
• Calculate, interpret, and evaluate the
internal rate of return (IRR).
Exercise 9 - 3
• Project Kelvin will cost $45,000 and
generate cash inflows of $20,000 per year
for the next 3 years
• Project Thompson will cost $275,000 and
generate cash inflows of $60,000 per year
for 6 years.
• Using an 8% cost of capital, calculate
each project’s NPV and make a
recommendation based on your findings
Exercise 9 - 3 Solution
Exercise 9 - 4
• Calculate the IRR for each of the following
projects and recommend best project.
• Project T-shirt requires initial investment
of $15,000 and generates cash inflows of
$8,000 per year for 4 years.
• Project Board Shorts requires an initial
investment of $25,000 and produces cash
inflows of $12,000 per year for 5 years.
Exercise 9 - 4 Solution
Project T-Shirt
• PV = -15,000
• N=4
• PMT = 8,000
• Solve for I
IRR = 39.08%
Problem 9 - 1
• Payback period
• Jordan Enterprises is considering a capital
expenditure that requires an initial investment of
$42,000 and returns after-tax inflows of $7,000
per year for 10 years. The firm has maximum
acceptable payback period of 8 years.
a) Determine the payback period for this project.
b) Should the company accept the project? Why?
Problem 9 - 1 Solution
(a)
$42,000 / $7,000 = 6 years
(b) The company should accept the
project, since 6 < 8.
Problem 9 - 3
• Choosing between 2
projects with acceptable
payback periods
• Each project requires
$100,000 investment
• Maximum payback period 4
years
a) Determine payback period
of each project.
b) Which one should they
choose?
c) Explain why is one of the
projects a better choice.
Year
Project A
Project B
1
$10,000
$40,000
2
$20,000
$30,000
3
$30,000
$20,000
4
$40,000
$10,000
5
$20,000
$20,000
Problem 9 - 3 Solution
Problem 9 - 4
• NPV
• Calculate the NPV for the following 20-year
projects. Comment on the acceptability of each
• Opportunity cost is 14%
a) Initial investment is $10,000; cash inflows are
$2,000 per year.
b) Initial investment is $10,000; cash inflows are
$2,000 per year.
c) Initial investment is $10,000; cash inflows are
$2,000 per year.
Problem 9 - 4 Solution
Problem 9 - 7
• NPV
• Car inventor has offered Simes choice of either one time
payment $1,500,000 today or a series of 5 year-end
payments of $385,000
a) If Simes has cost of capital 9%, which form of payment
would they choose?
b) What yearly payment would make the two offers identical in
value at a cost of capital of 9%
c) Would your answer be different if the yearly payments were
made at the beginning of each year? Show the difference.
d) The after-tax cash inflows are projected to $250,000 per
year for 15 years. Will this factor change the decision?
Problem 9 - 7 Solution
Problem 9 - 9
• NPV- exclusive projects
• Hook industries is
considering the
replacement of a drill
press
• Cost of capital is 15%
a) Calculate NPV of each
press.
b) Evaluate acceptability.
c) Rank the presses best
to worst
A
Init. Inv. $85,00
0
Year
B
C
$60,00
0
130,00
0
Cash Inflows (CFt)
1
$18,00
0
$12,00
0
$50,00
0
2
$18,00
0
$14,00
0
$30,00
0
3
$18,00
0
$16,00
0
$20,00
0
4
$18,00
0
$18,00
0
$20,00
0
5
$18,00
0
$20,00
0
$20,00
0
6
$18,00
$25,00
$30,00
Problem 9 - 9 Solution
Problem 9 - 9 Solution cont.
Problem 9 - 13
• IRR, investment life and cash inflows
• Oak enterprises accepts projects earning more than
15%. Oak is considering a 10 year project that
provides $10,000 annual cash inflows and requires
$61,450 initial investment.
a) Determine IRR. Is it acceptable?
b) Assuming cash inflows stay same how many
additional years would the flows have to continue to
make IRR 15%?
c) With given life, initial investment, and cost of capital
what is the minimum annual cash inflow the firm
should accept?
Problem 9 - 13 Solution
Problem 9 - 21
• Integrative - Complete
investment decision
• Existing
– 10yrs ago at $1,000,000
– Sells $1,200,000
• New
– Cost $2,200,000
– 5yrs, MACRS
– Sales $1,600,000 increase
per year
– Costs 50% of Sales
• Cost of Capital 11%
• Tax 40%
MACRS
Year
Percentage
1
20%
2
32%
3
19%
4
12%
5
12%
6
5%
a) Calculate initial investment.
b) Determine incremental operating
cash flows.
c) Determine the terminal cash flow.
d) Depict on a time line the relevant
cash flows.
Problem 9 - 21 Solution
Problem 9 - 21 Solution cont.