Fundamentals of Capital Budgeting

 

 

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10.17   Payback: Creative Solutions, Inc., has just invested $4,615,300 in equipment. The firm uses payback period criteria of not accepting any project that takes more than four years to recover its costs. The company anticipates cash flows of $644,386, $812,178, $943,279, $1,364,997, $2,616,300, and $2,225,375 over the next six years. Does this investment meet the firm’s payback criteria?

LO 3

 

 

10.18   Discounted payback: Timeline Manufacturing Co. is evaluating two projects. It uses payback criteria of three years or less. Project A has a cost of $912,855, and project B’s cost is $1,175,000. Cash flows from both projects are given in the following table. What are their discounted payback periods, and which will be accepted with a discount rate of 8 percent?

Year Project A Project B
1 $ 86,212 $586,212
2 $313,562 $413,277
3 $427,594 $231,199
4 $285,552  

LO 3

 

10.19   Payback: Regent Corp. is evaluating three competing pieces of equipment. Costs and cash flow projections for all three are given in the following table. Which would be the best choice based on payback period?

 

Year Type 1 Type 2 Type 3
0 $(1,311,450) $(1,415,888) $(1,612,856)
1 $212,566 $586,212 $786,212
2 $269,825 $413,277 $175,000
3 $455,112 $331,199 $175,000
4 $285,552 $141,442 $175,000
5 $121,396   $175,000
6     $175,000

LO 3

 

10.20   Discounted payback: Nugent Communication Corp. is investing $9,365,000 in new technologies. The company expects significant benefits in the first three years after installation (as can be seen by the cash flows), and smaller constant benefits in each of the next four years. What is the discounted payback period for the project assuming a discount rate of 10 percent?

 

    Years    
  1 2 3 4 – 7
Cash flows $2,265,433 $4,558,721 $3,378,911 $1,250,000

LO 3

 

 

10.21   Modified internal rate of return (MIRR): Morningside Bakeries has recently purchased equipment at a cost of $650,000. The firm expects to generate cash flows of $275,000 in each of the next four years. The cost of capital is 14 percent. What is the MIRR for this project?

LO 5

 

 

10.22   Modified internal rate of return (MIRR): Sycamore Home Furnishings is considering acquiring a new machine that can create customized window treatments. The equipment will cost $263,400 and will generate cash flows of $85,000 over each of the next six years. If the cost of capital is 12 percent, what is the MIRR on this project?

LO 5

 

 

 

10.23   Internal rate of return:Great Flights, Inc., an aviation firm, is considering purchasing three aircraft for a total cost of $161 million. The company would lease the aircraft to an airline. Cash flows from the proposed leases are shown in the following table. What is the IRR of this project?

Years Cash Flow
1–4 $23,500,000
5–7 $72,000,000
8–10 $80,000,000

 

 

 

 

LO 5

 

 

10.24   Internal rate of return:  Refer to problem 10.5.  Compute the IRR for both production system 1 and production system 2.  Which has the higher IRR?  Which production system has the highest NVP?  Explain why the IRR and NPV rankings of systems 1 and 2 are different?

LO 5

 

10.25  Internal rate of return:  Ancala Corporation is considering investments in two new golf apparel lines for next season: golf hats and belts.  Due to a funding constraint, these lines are mutually exclusive.  A summary of each project’s estimated cash flows over its three -year life, as well as the IRRs and NPVs of each are outlined below.  The CFO of the firm has decided to manufacture the belts; however, the CEO of Ancala is questioning this decision given that the IRR is higher for manufacturing hats.   Explain to the CEO why the IRRs and NPVs of the belt and hat projects disagree?  Is the CFO’s decision the correct .

 

Year Golf Belts Golf Hats
0 -$1,000 -$500
1 1,000 500
2 500 300
3 500 300
     
NPV $697.97 $427.87
IRR 54% 61%

 

LO 5

 

10.26   Internal rate of return:Compute the IRR on the following cash flow streams:

a.         An initial investment of $25,000 followed by a single cash flow of $37,450 in year 6.

b.         An initial investment of $1 million followed by a single cash flow of $1,650,000 in year 4.

c.         An initial investment of $2 million followed by cash flows of $1,650,000 and $1,250,000 in years 2 and 4, respectively.

LO 5

 

 

10.27   Internal rate of return:Compute the IRR for the following project cash flows.

a.         An initial outlay of $3,125,000 followed by annual cash flows of $565,325 for the next eight years

b.         An initial investment of $33,750 followed by annual cash flows of $9,430 for the next five years

c.         An initial outlay of $10,000 followed by annual cash flows of $2,500 for the next seven years

LO 5

 

ADVANCED

 

10.28   Draconian Measures, Inc., is evaluating two independent projects. The company uses a 13.8 percent discount rate for such projects. The cost and cash flows are shown in the following table. What are the NPVs of the two projects?

 

Year Project 1 Project 2
0 $(8,425,375) $(11,368,000)
1 $3,225,997 $2,112,589
2 $1,775,882 $3,787,552
3 $1,375,112 $3,125,650
4 $1,176,558 $4,115,899
5 $1,212,645 $4,556,424
6 $1,582,156  
7 $1,365,882  

LO 2

 

 

10.29   Refer to Problem 10.28.

a.         What are the IRRs for the projects?

b.         Does the IRR criterion indicate a different decision than the NPV criterion?

c.         Explain how you would expect the management of Draconian Measures to decide.

LO 5

 

10.30   Dravid, Inc., is currently evaluating three projects that are independent. The cost of funds can be either 13.6 percent or 14.8 percent depending on their financing plan. All three projects cost the same at $500,000. Expected cash flow streams are shown in the following table. Which projects would be accepted at a discount rate of 14.8 percent? What if the discount rate was 13.6 percent?

 

Year Project 1 Project 2 Project 3
1 0 0 $245,125
2 $125,000 0 $212,336
3 $150,000 $500,000 $112,500
4 $375,000 $500,000 $74,000

 

 

LO 2

10.31   Intrepid, Inc., is looking to invest in two or three independent projects. The costs and the cash flows are given in the following table. The appropriate cost of capital is 14.5 percent. Compute the IRRs and identify the projects that will be accepted.

 

Year Project 1 Project 2 Project 3
0 $(275,000) $(312,500) $(500,000)
1 $63,000 $153,250 $212,000
2 $85,000 $167,500 $212,000
3 $85,000 $112,000 $212,000
4 $100,000   $212,000

LO 5

 

10.32   Jekyll & Hyde Corp. is evaluating two mutually exclusive projects. The cost of capital is 15 percent. Costs and cash flows are given in the following table. Which project should be accepted?

 

Year Project 1 Project 2
0 $(1,250,000) $(1,250,000)
1 $250,000 $350,000
2 $350,000 $350,000
3 $450,000 $350,000
4 $500,000 $350,000
5 $750,000 $350,000

LO 5

 

10.33   Larsen Automotive, a manufacturer of auto parts, is considering investing in two projects. The company typically compares project returns to a cost of funds of 17 percent. Compute the IRRs based on the given cash flows, and state which projects will be accepted.

Year Project 1 Project 2
0 $(475,000) $(500,000)
1 $300,000 $117,500
2 $110,000 $181,300
3 $125,000 $244,112
4 $140,000 $278,955

LO 5

 

 

10.34   Compute the IRR for each of the following projects:

Year Project 1 Project 2 Project 3
0 $(10,000) $(10,000) $(10,000)
1 $4,750 $1,650 $800
2 $3,300 $3,890 $1,200
3 $3,600 $5,100 $2,875
4 $2,100 $2,750 $3,400
5   $800 $6,600

LO 5

 

 

10.35   Primus Corp. is planning to convert an existing warehouse into a new plant that will increase its production capacity by 45 percent. The cost of this project will be $7,125,000. It will result in additional cash flows of $1,875,000 for the next eight years. The company uses a discount rate of 12 percent.

a.         What is the payback period?

b.         What is the NPV for this project?

c.         What is the IRR?

LO 2, LO 3, LO 5

 

 

10.36   Quasar Tech Co. is investing $6 million in new machinery that will produce the next-generation routers. Sales to its customers will amount to $1,750,000 for the next three years and then increase to $2.4 million for three more years. The project is expected to last six years and cost, excluding depreciation will be $898,620 annually. The machinery will be depreciated to a salvage value of 0 over 6 years using the straight-line method. The company’s tax rate is 30 percent, and the cost of capital is 16 percent.

a.         What is the payback period?

b.         What is the average accounting return (ARR)?

c.         Calculate the project NPV.

d.         What is the IRR for the project?

LO 2, LO 3, LO 5

 

 

10.37   Skywards, Inc., an airline caterer, is purchasing refrigerated trucks at a total cost of $3.25 million. After-tax net income from this investment is expected to be $750,000 for the next five years. Annual depreciation expense will be $650,000. The cost of capital is 17 percent.

a.         What is the discounted payback period?

b.         Compute the ARR.

c.         What is the NPV on this investment?

d.         Calculate the IRR.

LO 2, LO 3, LO 4, LO 5

 

 

10.38   Trident Corp. is evaluating two independent projects. The costs and expected cash flows are given in the following table. The company’s cost of capital is 10 percent.

Year A B
0 $(312,500) $(395,000)
1 $121,450 $153,552
2 $121,450 $158,711
3 $121,450 $166,220
4 $121,450 $132,000
5 $121,450 $122,000

 

a.         Calculate the projects’ NPV.

b.         Calculate the projects’ IRR.

c.         Which project should be chosen based on NPV? Based on IRR? Is there a conflict?

d.         If you are the decision maker for the firm, which project or projects will be accepted? Explain your reasoning.

LO 2,  LO 5

10.39   Tyler, Inc., is considering switching to a new production technology. The cost of equipment will be $4 million. The   discount rate is 12 percent. The cash flows that the firm expects to generate are as follows.

Years CF
0 $(4,000,000)
1-2 0
3–5 $845,000
6–9 $1,450,000

 

a.         Compute the payback and discounted payback period for the project.

b.         What is the NPV for the project? Should the firm go ahead with the project?

c.         What is the IRR, and what would be the decision under the IRR?

LO 2, LO 3, LO 5

10.40.  Given the following cash flows for a capital project, calculate the NPV and IRR. The required rate of return is 8 percent.

 

Year
  0 1 2 3 4 5
Cash flow –50,000 15,000 15,000 20,000 10,000 5,000

 

NPV                IRR

a.         $1,905             10.9%

b.         $1,905             26.0%

c.         $3,379             10.9%

d.         $3,379             26.0%

 

LO 2

10.41.  Given the following cash flows for a capital project, calculate its payback period and discounted payback period. The required rate of return is 8 percent.

 

Year
  0 1 2 3 4 5
Cash flow –50,000 15,000 15,000 20,000 10,000 5,000

 

The discounted payback period is

a.         0.16 years longer than the payback period.

b.         0.80 years longer than the payback period.

c.         1.01 years longer than the payback period.

d.         1.85 years longer than the payback period.

 

LO 3

10.42.  An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in Year 2, and $120 in Year 3. The required rate of return is 20 percent. The net present value is closest to

a.         $42.22

b.         $58.33

c.         $68.52

d.         $98.95

 

LO 2

 

 

 

10.43.  An investment of $150,000 is expected to generate an after-tax cash flow of $100,000 in one year and another $120,000 in two years. The cost of capital is 10 percent. What is the internal rate of return?

a.         28.19 percent

b.         28.39 percent

c.         28.59 percent

d.         28.79 percent

 

LO 5

10.44.  An investment requires an outlay of 100 and produces after-tax cash flows of $40 annually for four years. A project enhancement increases the outlay by $15 and the annual after-tax cash flows by $5. How will the enhancement affect the NPV profile?  The vertical intercept of the NPV profile of the project shifts:

 

a.         up and the horizontal intercept shifts left.

b.         up and the horizontal intercept shifts right.

c.         down and the horizontal intercept shifts left.

d.         down and the horizontal intercept shifts right.

 

LO 2

 

Sample Test Problems

 

10.1     Net present value: Techno Corp. is considering developing new computer software. The cost of development will be $675,000, and the company expects the revenue from the sale of the software to be $195,000 for each of the next six years. If the company uses a discount rate of 14 percent, what is the net present value of this project?

 

10.2     Payback method:Parker Office Supplies is considering replacing the company’s outdated inventory-management software. The cost of the new software will be $168,000. Cost savings is expected to be $43,500 for each of the first three years and then to drop off to $36,875 for the following two years. What is the payback period for this project?

 

10.3     Accounting rate of return: Fresno, Inc., is expecting to generate after-tax income of $156,435 in each of the next three years. The average book value of its equipment over that period will be $322,500. If the firm’s acceptance decision on any project is based on an ARR of 40 percent, should this project be accepted?

10.4     Internal rate of return: Refer to  Sample Test Problem 10.1. What is the IRR on this project?

 

 

10.5     Net present value: Raycom, Inc. needs a new overhead crane and two alternatives are available. Crane T costs $1.35 million and will produce cost savings of $765,000 for the