Capital Budgeting Examples

Instructions Question 1 Question 5

Question 2 Question 6
Question 3 Question 7
Question 4 Question 8
Copyright 2008 McGraw-Hill/Irwin
Copyright 2004 McGraw-Hill/Irwin
Capital Budgeting Examples
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Copyright 2008 McGraw-Hill/Irwin
Copyright 2008 McGraw-Hill/Irwin

Question 1: Determining the value of a tax shield
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Select the red highlighted items below for tips and suggestions to complete this problem.
Assumptions
Installation cost $50,000
Tax rate 35%
Opportunity cost 5%
MACRS percentages Annual Tax
Years Percentages Depreciation Shield
1 20%
2 32%
3 19.2%
4 11.52%
5 11.52%
6 5.76%
Value of tax shield if:
Installations costs expensed year 1
Value of tax shield if:
Capitalized and depreciated FORMULA
Copyright 2008 McGraw-Hill/Irwin

Question 2: Analyze capital projects under different tax scenarios
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Assumptions
Projected cash flows:
Initial investment ($100,000)
Before-tax cash inflow $26,000
Company B tax rate 35%
Opportunity cost of capital 8%
Year
1 2 3 4 5 6
5-year MACRS Schedule:
Company A: Year
Projected cash flows 1 2 3 4 5 6
Cash in
Tax 0 0 0 0 0 0
Cash flow
Company B: Year
Projected cash flows 1 2 3 4 5 6
Cash in
Depreciation
Taxable income
Tax
Net income
Cash flow
(a) Calculate project NPV for each company.
Company A NPV: FUNCTION
Company B NPV:
(b) What is the IRR of the after-tax cash flows for each company? What does comparison of the
IRRs suggest is the effective corporate tax rate?
IRR for A FORMULA
IRR for B
Effective tax rate 0.0%
Help with Excel's NPV function
Help with Excel's IRR function
Copyright 2008 McGraw-Hill/Irwin

Question 3
Student Name:
Course Name:
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Click here to use Tables 7.5 and 7.6 for the answer part a.
Click here to use Tables CBE.1 and CBE.2 for the answers to parts b and c.
c. Continue with the assumed $15 million capital investment and the 11% cost of capital.
What if sales, cost of goods sold, and net working capital are each 10% higher
in every year? Recalculate NPV. Note: Enter the revised sales, cost, and workingcapital
forecasts in the spreadsheet for Table CBE.1.
a. How does the guano projects NPV change if IM&C is forced to use the seven-year
MACRS tax depreciation schedule?
b. New engineering estimates raise the possibility that capital investment will be more
than $10 million, perhaps as much as $15 million. On the other hand, you believe
that the 20% cost of capital is unrealistically high and that the true cost of capital is
about 11%. Is the project still attractive under these alternative assumptions?
Copyright 2008 McGraw-Hill/Irwin

Capital Budgeting Exercises
Student Name:
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Select the red highlighted items below for tips and suggestions to complete this problem.
a) Read the notes to the table carefully. Which entries make sense? Which do not? Why or why not?
Consider each of the items listed and type your answer in the text box below. Attach any additional sheets if necessary.
Item
Capital Expenditure
Research and Development
Working Capital
Revenues
Operating Costs
Overhead
Depreciation
Interest
Taxes
Net Cash Flow
b) What additional information would you need to construct a version of TABLE CBE.7 that makes sense?
List the items for which you would like more information below:
1
2
3
4
5
6
7
8
9
10
click here to begin typing
Copyright 2008 McGraw-Hill/Irwin
c) Construct such a table and recalculate NPV. Make additional assumptions as necessary.
Assumptions
1 Enter all figures in thousands of dollars (e.g., $100,000 is entered as 100).
2
3
4
5
6
7
8
9
10
11
12
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
1
2
3
4
5
6
7
8
9
10
11
12
13 Net Cash Flows FORMULA
14 Present value
16 Net present value = FUNCTION Help with Excel's SUM function
Copyright 2008 McGraw-Hill/Irwin

Question 5: Using NPV to evaluate a capital project
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Assumptions
Initial investment ($000) Enter all figures in thousands of dollars (e.g., $100,000 is entered as 100).
Resale Value year 8
Working Capital Investment
Projected working capital
(% of Sales)
Yearly rental income
Rental Income growth rate
First year sales
Sales growth rate
Manufacturing costs
(% of Sales)
Tax rate
Cost of capital
Year
1 2 3 4 5 6 7 8 9
Sales
Manufacturing Costs
Depreciation
Earnings before tax
Taxes
Net Income
Working Capital
Increase in W.C.
Lost After Tax Rental Income FORMULA
Initial Investment
Sale of Plant
Tax on Sale
Net Cash Flows FORMULA
Present value
Net present value = FUNCTION Help with Excel's SUM function
Copyright 2008 McGraw-Hill/Irwin

Question 6: Evaluating alternative capital asset decisions
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Select the red highlighted items below for tips and suggestions to complete this problem.
The net cash flows for each copier have been calculated for you and are shown below.
Select each cell to see the formula used for this calculation.
Parts A through D below have been structured to help you develop the solution.
Assumptions
Current Copier Net Cash Flows: New Copier Projected Net Cash Flows
Net * Net *
Years Cash Flow Years Cash Flow
1 -675 0 -25,000
2 -675 1 600
3 -4,575 2 1,493
4 -4,889 3 880
5 -5,200 4 443
6 -5,200 5 131
6 131
7 131
* After taxes 8 -261
Cost of capital 7%
Income tax rate 35%
A. What is the present value of each copier?
Present value of current copier
Equivalent annual cost $0.00
Present value of new copier
B. If you replace the current copier now, when the book value is $6,248 and
the resale value is $8,000, what will be the present value of the decision?
Present value FORMULA
Equivalent annual cost FORMULA
C. If you replace the copier in 2 years, when the book value is $2,676 and what will be the present value of the decision?
the resale value is $3,500, what will be the present value of the decision?
Present value
Equivalent annual cost $0
D. If you replace the copier in 6 years, what will be the present value of the decision? Assume a zero book and
resale value.
Present value FORMULA
Equivalent annual cost FORMULA
When should the copier be replaced?
Help with Excel's PV function
Copyright 2008 McGraw-Hill/Irwin

Question 7
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0 1 2 3 4
Cash flows A 40000 10000 10000 10000
PV Cash flows A
Cash flows B 50000 8000 8000 8000 8000
PV Cash flows B
Annuity Factor - 3 years FUNCTION
Annuity Factor - 4 years FUNCTION
Equivalent Annual Cost A
Equivalent Annual Cost B
b. Which machine should Borstal buy?
c. How much would you actually have to charge in each future year if there is steady 8% per year inflation?
Click here for help with Excel's PV function
Copyright 2008 McGraw-Hill/Irwin

Question 8
Student Name:
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0 1 2 3 4
Cash flows A 40000
PV Cash flows A
Cash flows B 50000
PV Cash flows B
Annuity Factor - 3 years FUNCTION
Annuity Factor - 4 years FUNCTION
Equivalent Annual Cost A
Equivalent Annual Cost B
0
c. How much would you actually have to charge in each future year if there is steady 8% per year inflation?
Click here for help with Excel's PV function
Copyright 2008 McGraw-Hill/Irwin
Period
0 1 2 3 4 5
1. Capital investment 10,000
2. Accumulated depn. 1,583 3,167 4,750 6,333 7,917
3. Year-end book value 10,000 8,417 6,833 5,250 3,667 2,083
4. Working capital 550 1,289 3,261 4,890 3,583
5. Total book value (3 + 4) 8,967 8,122 8,511 8,557 5,666
6. Sales 523 12,887 32,610 48,901 35,834
7. Cost of goods sold 837 7,729 19,552 29,345 21,492
8. Other costs 4,000 2,200 1,210 1,331 1,464 1,611
9. Depreciation 1,583 1,583 1,583 1,583 1,583
10. Pretax profit -4,000 -4,097 2,365 10,144 16,509 11,148
11. Tax -1,400 -1,434 828 3,550 5,778 3,902
12. Profit after tax (10 - 11) -2,600 -2,663 1,537 6,593 10,731 7,246
Notes:
No. of years depreciation 6
Assumed salvage value in depreciation calculation 500
Tax rate (percent) 35
TABLE CBE.1 IM&C's guano project -- projections ($ thousands) reflecting inflation and straight line depreciation
Main Menu
6 7
-1,949
9,500 0
500 0
2,002 0
2,502 0
19,717
11,830
1,772
1,583 0
4,532 1,449
1,586 507
2,946 942
TABLE CBE.1 IM&C's guano project -- projections ($ thousands) reflecting inflation and straight line depreciation
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Question
Period
0 1 2 3 4
1. Sales 0 523 12,887 32,610 48,901
2. Cost of goods sold 0 837 7,729 19,552 29,345
3. Other costs 4,000 2,200 1,210 1,331 1,464
4. Tax -1,400 -1,434 828 3,550 5,778
5. Cash flow from operations (1 - 2 - 3 - 4) -2,600 -1,080 3,120 8,177 12,314
6. Change in working capital -550 -739 -1,972 -1,629
7. Capital investment and disposal -10,000 0 0 0 0
8. Net cash flow (5 + 6 + 7) -12,600 -1,630 2,381 6,205 10,685
9. Present value -12,600 -1,358 1,654 3,591 5,153
Net present value = 3,520
Cost of capital (percent) 20
TABLE CBE.2 IM&C's guano project -- initial cash flow analysis with straight-line depreciation ($ thousands)
Go back to Table 7.1 to change Sales, Cost of goods sold, etc.
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5 6 7
35,834 19,717 0
21,492 11,830 0
1,611 1,772 0
3,902 1,586 507
8,829 4,529 -507
1,307 1,581 2,002
0 0 1,949
10,136 6,110 3,444
4,074 2,046 961
TABLE CBE.2 IM&C's guano project -- initial cash flow analysis with straight-line depreciation ($ thousands)
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Recovery-Period Years
Class 1 2 3 4 5 6 7 8
3-year 33.33 44.45 14.81 7.41
5-year 20.00 32.00 19.20 11.52 11.52 5.76
7-year 14.29 24.49 17.49 12.49 8.93 8.92 8.93 4.45
10-year 10.00 18.00 14.40 11.52 9.22 7.37 6.55 6.55
15-year 5.00 9.50 8.55 7.70 6.93 6.23 5.90 5.90
20-year 3.75 7.22 6.68 6.18 5.71 5.28 4.89 4.52
TABLE CBE.4 Tax Depreciation Schedules by Recovery-Period Class
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9 10 11 12 13 14 15 16 17
6.56 6.55 3.29
5.90 5.90 5.90 5.90 5.91 5.90 5.91 2.99
4.46 4.46 4.46 4.46 4.46 4.46 4.46 4.46 4.46
TABLE CBE.4 Tax Depreciation Schedules by Recovery-Period Class Back to
Question
18 19 20 21
4.46 4.46 4.46 2.23
No. of years depreciation (3, 5 or 7 years only) 5
Tax rate (percent) 35
0 1 2
MACRS % 20.0 32.0
Tax depreciation (MACRS % x depreciable investment) 2,000 3,200
1 Sales 0 523 12,887
2 Cost of goods sold 0 837 7,729
3 Other costs 4,000 2,200 1,210
4 Tax depreciation 0 2,000 3,200
5 Pretax profits -4,000 -4,514 748
6 Tax -1,400 -1,580 262
0 1 2
1. Sales 0 523 12,887
2. Cost of goods sold 0 837 7,729
3. Other costs 4,000 2,200 1,210
4. Tax -1,400 -1,580 262
5. Cash flow from operations (1 - 2 - 3 - 4) -2,600 -934 3,686
6. Change in working capital -550 -739
7. Capital investment & disposal -10,000 0 0
8. Net cash flow (5 + 6 + 7) -12,600 -1,484 2,947
9. Present value -12,600 -1,237 2,047
Net present value = 3,802
Cost of capital (percent) 20
TABLE CBE.5 Tax payments on IM&C's guano project ($ thousands)
TABLE CBE.6 IM&C's guano project -- revised cash flow analysis with MACRS depreciation ($ thousands)
Note: Vary depreciable life by changing inputs in these tables. Go back to Tables 7.1 or 7.2 to change sales, cost of goods sold, cost of capital etc.
Main Menu
Period
3 4 5 6 7
19.2 11.5 11.5 5.8 0.0
1,920 1,152 1,152 576 0
32,610 48,901 35,834 19,717 0
19,552 29,345 21,492 11,830 0
1,331 1,464 1,611 1,772 0
1,920 1,152 1,152 576 0
9,807 16,940 11,579 5,539 1,949
3,432 5,929 4,053 1,939 682
Period
3 4 5 6 7
32,610 48,901 35,834 19,717 0
19,552 29,345 21,492 11,830 0
1,331 1,464 1,611 1,772 0
3,432 5,929 4,053 1,939 682
8,295 12,163 8,678 4,176 -682
-1,972 -1,629 1,307 1,581 2,002
0 0 0 0 1,949
6,323 10,534 9,985 5,757 3,269
3,659 5,080 4,013 1,928 912
TABLE CBE.5 Tax payments on IM&C's guano project ($ thousands)
TABLE CBE.6 IM&C's guano project -- revised cash flow analysis with MACRS depreciation ($ thousands)
Note: Vary depreciable life by changing inputs in these tables. Go back to Tables 7.1 or 7.2 to change sales, cost of goods sold, cost of capital etc.
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