CHAPTER 11
CAPITAL BUDGETING
SOLUTIONS TO SELF-TEST EXERCISES
SELF-TEST EXERCISE 11.1:
TRADITIONAL PAYBACK PERIOD
The Millers are considering a $200,000 expansion for their existing retail outlet. The
expansion would generate $35,000 in cash each year over the next 10 years. Calculate
CompuTech’s payback period.
Payback period
$200,000
= 5.71 years
$35,000
SELF-TEST EXERCISE 11.2:
PAYBACK RECIPROCAL
A retailer is interested in selling a retail business to the Millers for $1 million. This
includes all physical assets, the working capital, and goodwill. The Millers estimate,
based on the company’s historical financial statements that the annual cash inflows would
be around $195,000. Calculate the project’s payback reciprocal.
Payback reciprocal
$195,000
= 19.5%
$1,000,000
SELF-TEST EXERCISE 11.3:
NET PRESENT VALUE
Using the information in Self-Test Exercise 11.1, and assuming that CompuTech’s
weighted average cost of capital is 8%, calculate the project’s net present value.
Net present value using the 8% discount rate:
Cash outflow
Present value ($35,000 × 6.7101)
Net present value
$( 200,000)
$234,854
$ 34,854
© 2014 by Nelson Education Ltd.
11-2
Chapter 11 Capital Budgeting
SELF-TEST EXERCISE 11.4:
NET PRESENT VALUE: PURCHASE OF EXISTING BUSINESS
Use the information in Self-Test Exercise 11.2, and assume that the Millers want to make
20% on their investment and would like to sell the retail store for $4 million in the 20th
year. Calculate the company’s net present value, and calculate the net present values by
using the following discount rates: 18%, 19%, 20%, 21%, and 22%.
Net present value using the 20% discount rate:
Cash outflow
$(1,000,000)
Present value $(195,000 × 4.8696)
949,572
Sale of store $(4,000,000 × 0.02608)
104,320
Total present value
1,053,892
Net present value
$
53,892
For each incremental percentage, the net present value is as follows:
NPV
@ 18% =
$189,808
NPV
@ 19% =
$118,012
NPV
@ 20% =
$53,892
NPV
@ 21% =
$( 3,565)
NPV
@ 22% =
$( 55,282)
SELF-TEST EXERCISE 11.5:
INTERNAL RATE OF RETURN
Use the information in Self-Test Exercise 11.1 to calculate the project’s internal rate of
return.
Use the payback period as a factor (see answer to Self-Test Exercise 11.1) and go to
Table D in row 10. By crossing the discount columns, reach the factor that is closest to
5.71 which is at 12% (5.6502).
Cash outflow
Cash inflow ($35,000 × 5.6502)
Net present value
$ (200,000)
$197,757
$ ( 2,243)
To calculate the IRR, you have to multiply the $35,000 amount by a factor using a
discount rate that is slightly less than 12%; to be exact, the rate is 11.73%.
© 2014 by Nelson Education Ltd.
Chapter 11 Capital Budgeting
11-3
SELF-TEST EXERCISE 11.6:
INTERNAL RATE OF RETURN
Use the information in Self-Test Exercises 11.2 and 11.4 to calculate the project’s
internal rate of return.
As shown in Self-Test Exercise 11.4, the rate that makes the inflows equal to the outflow
is between 20% and 21%, closer to 21%. By interpolation, or using a financial calculator,
the internal rate of return gives exactly 20.93%.
SELF-TEST EXERCISE 11.7:
PROFITABILITY INDEX
Use the information in Self-Test Exercises 11.1 and 11.3 to calculate the profitability
index.
By using the information obtained in the NPV calculation in Self-Test Exercise 11.3
divide the discounted cash inflows (8%) by the cash outflows.
$234,854
= 1.17
$200,000
SELF-TEST EXERCISE 11.8:
PROFITABILITY INDEX
Use the information in Self-Test Exercises 11.2 and 11.4 to calculate the profitability
index.
By using the information obtained in the NPV calculation in Self-Text Exercise 11.4,
divide the discounted cash inflows (20%) by the cash outflows.
$1,053,892
= 1.05
$1,000,000
© 2014 by Nelson Education Ltd.
11-4
Chapter 11 Capital Budgeting
SELF-TEST EXERCISE 11.9:
BUY VERSUS LEASE OPTION
Questions
If the Millers want to make 30%, should they buy or lease the retail store? To answer this
question, calculate the following:
1. Net present value
2. Internal rate of return
Option A: Purchase
1. Net present value: At 30%, the net present value is $104,033.
2. Internal rate of return: The internal rate of return is 33.84%.
Option B: Leasing
1. Present value: At 30%, the present value is $170,492 ($70,000 × 2.4356).
2. The IRR cannot be calculated since there is no cash outflow.
Since the leasing option offers a greater NPV, it would be more economically
advantageous to lease. Also, leasing is considered less risky than buying and there is no
cash outflow and no financing would be required.
SELF-TEST EXERCISE 11.10:
PROJECT ANALYSIS
These are the numbers that were presented in the opening case on page 463.
Years
Calculations
Factors
Factors
@ 11% PV
@ 20% PV
0
(350)
1
(25)
2
5
3
100
4
125
5
140
6
150
7
150
8
150
9
150
10
150
10
900
Net present value
-(350)
0.9009 (23)
0.8116
4
0.7312 73
0.6587 83
0.5934 83
0.5346 80
0.4817 72
0.4339 65
0.3909 59
0.3522 53
0.3522 317
516
-- (350)
0.8333 (21)
0.6944
3
0.5787
58
0.4822
60
0.4019
56
0.3349
51
0.2791
42
0.2326
35
0.1938
29
0.1615
24
0.1615 146
133
© 2014 by Nelson Education Ltd.
Factors
@ 25%
-0.8000
0.6400
0.5120
0.4096
0.3278
0.2621
0.2097
0.1678
0.1342
0.1074
0.1074
P.V.
(350)
(20)
3
51
51
46
40
31
25
20
16
97
10
Chapter 11 Capital Budgeting
Questions
1. What is CompuTech’s NPV using 11% and 20% weighted average cost of capital?
At 11% is
At 20% is
At 25% is
$ 516,046
$ 132,688
$ 10,295
2. What is the retail store’s payback period?
Payback is 5.03 years
3. What is CompuTech’s IRR?
The internal rate of return is 25.52%.
4. What is the PI?
Using the 11% cost of capital ($516,000 + $350,000 = $866,000)
$866,000
= 2.47
$350,000
5. Should the Millers go ahead with the opening?
Yes. The Millers should go ahead with the decision because the cost of capital is 11%
and the hurdle rate is 20% while the project gives a 25.5% IRR.
© 2014 by Nelson Education Ltd.
11-5