Ghani Rais Azka

29118007
YP 59 A
Capital Budgeting Techniques
Problem 10-27

The High-Flying Growth Company (HFGC) is considering to invest in project that offer
the highest rate of return possible.
Two projects are currently under review.

Year Plant Expansion Plant Introduction

0 $ -3,500,000 $ -500,000
1 $ 1,500,000 $ 250,000
2 $ 2,000,000 $ 350,000
3 $ 2,500,000 $ 375,000
4 $ 2,750,000 $ 425,000

Average rate of return 20%

Firm's cost of capital 20%

a. Calculate the NPV, IRR, and PI for both project

Project
Plant Expansion Plant Introduction
NPV $ 1,911,844.14 $ 373,360.34
IRR 44% 52%
PI 1.55 1.75

b. Rank the projects based on their NPVs, IRRs, and Pis

Plant Expansion Plant Introduction

NPV $ 1,911,844.14 $ 373,360.34
Rank 1 Rank 2

Plant Expansion Plant Introduction

IRR 44% 52%
Rank 2 Rank 1

Plant Expansion Plant Introduction

PI 1.55 1.75
Rank 2 Rank 1
c. Do the rankings in part b agree or not? If not, wht not?

Based on the rankings, show that plant expansion yield higher

NPV and plant indtroduction yield higher IRR and PI. IRR uses
one discount rate, which is still acceptable when evaluating
project that share a common discount rate. But IRR does not
account for change, making it a poor option for long term
projects with varying discount rate

d. The firm can only afford to undertake one of these investments, and the CEO Favors the product introduction because it offe

I think based on the calculation of IRR, that yield plant

introduction higher than the plant expansion. Therefore the
firm should choose plant introduction as their next project
duct introduction because it offers a higher rate of return than plant expansion
Lombard Company is contemplating the purchase of a new high-speedwidget grinder to replace the existing grinder

The existing grinder

purchased 2 years ago
installed cost $ 60,000
Selling price $ 70,000

using MACRS 5-year recovery period

New grinder cost

price $ 105,000
installed cost $ 5,000
5-year usable life would be depreciated under MACRS using a 5-year recovery period
Account receivable $ 40,000
Inventories $ 30,000
Account payable $ 58,000
Selling price $ 29,000

Tax rate 40%

Earnings before depreciation, interest, and taxes

Year New Grinder
1 $ 43,000
2 $ 43,000
3 $ 43,000
4 $ 43,000
5 $ 43,000

a. Calculate the initial investment associated with the replacement of the existing grinder by the new one
Change in working capital $ 12,000

Calculating book value

2 years 20% 32%
Book value $ 28,800
Gain $ 41,200
Taxes on gain $ 16,480

Installed cost of new grinder

cost of new grinder $ 105,000
installation cost $ 5,000
total installed cost-proposed(depreciable value) $ 110,000
After tax proceed from sale of existing grinder
Proceed from sale of existing grinder $ 70,000
(-)Tax on sale of the $ 16,480
Total after-tax proceeds $ 53,520
Change in net working capital $ 12,000
Initial Investment $ 68,480

b. Determine the incremental operating cash flow associated with the proposed grinder replacement
Depreciation expende for existing grinder and new grinder
With New Grinder
Applicable MACRS
depreciation
Year Cost percentages
1 $ 110,000 20%
2 $ 110,000 32%
3 $ 110,000 19%
4 $ 110,000 12%
5 $ 110,000 12%
6 $ 110,000 5%
Total 100%

With Existing Grinder 1 $ 60,000 19%

2 $ 60,000 12%
3 $ 60,000 12%
4 $ 60,000 5%
5
6
Total

Calculation of operating cash flow

With new grinder Year 1 Year 2 Year 3
Revenue $ - $ - $ -
(-) Expenses (excluding depreciation and interest) $ - $ - $ -
Earnings before depreciation, interest, and taxes $ 43,000 $ 43,000 $ 43,000
(-) Depreciation $ 22,000 $ 35,200 $ 20,900
Earnings before interest and taxes $ 21,000 $ 7,800 $ 22,100
(-) Taxes (rate,T = 40%) $ 8,400 $ 3,120 $ 8,840
Net operating profit after taxes $ 12,600 $ 4,680 $ 13,260
(+) Depreciation $ 22,000 $ 35,200 $ 20,900
Operating cash flow $ 34,600 $ 39,880 $ 34,160

With existing grinder Year 1 Year 2 Year 3

Revenue $ - $ - $ -
(-) Expenses (excluding depreciation and interest) $ - $ - $ -
Earnings before depreciation, interest, and taxes $ 26,000 $ 24,000 $ 22,000
(-) Depreciation $ 11,400 $ 7,200 $ 7,200
Earnings before interest and taxes $ 14,600 $ 16,800 $ 14,800
(-) Taxes (rate,T = 40%) $ 5,840 $ 6,720 $ 5,920
Net operating profit after taxes $ 8,760 $ 10,080 $ 8,880
(+) Depreciation $ 11,400 $ 7,200 $ 7,200
Operating cash flow $ 20,160 $ 17,280 $ 16,080

Incremental Cashflow
Year New Grinder Existing Grinder
1 $ 34,600 $ 20,160
2 $ 39,880 $ 17,280
3 $ 34,160 $ 16,080
4 $ 31,080 $ 13,200
5 $ 31,080 $ 10,800
6 $ 2,200 $ -

c. Detemine the terminal cash flow expected at the end of year 5 from the proposed grinder replacement
After-tax proceeds from sale of new grinder
Proceeds from sale of new grinder $ 29,000
(-) Tax on sale of new grinder $ 9,400
Total after-tax proceeds: new grinder $ 19,600
(-) After-tax proceeds from sale of existing machine
Proceeds from sale of existing grinder $ -
(-)Tax on sale of existing grinder $ -
Total after-tax proceeds: existing grinder $ -
(+) Change in net working capital $ 12,000
Terminal cashflow $ 31,600

d. Depict on a time line the relevant cash flow associated with the proposed grinder replacement decision

$14.440 $22.600 $18.080

0 1 2 3

-$68.480
xisting grinder

tion, interest, and taxes

Existing Grinder
$ 26,000
$ 24,000
$ 22,000
$ 20,000
$ 18,000
Depreciation
$ 22,000
$ 35,200
$ 20,900
$ 13,200
$ 13,200
$ 5,500
$ 110,000

$ 11,400
$ 7,200
$ 7,200
$ 3,000
$ -
$ -
$ 28,800

Year 4 Year 5 Year 6

$ - $ - $ -
$ - $ - $ -
$ 43,000 $ 43,000
$ 13,200 $ 13,200 $ 5,500
$ 29,800 $ 29,800 $ -5,500
$ 11,920 $ 11,920 $ -2,200
$ 17,880 $ 17,880 $ -3,300
$ 13,200 $ 13,200 $ 5,500
$ 31,080 $ 31,080 $ 2,200

Year 4 Year 5 Year 6

$ - $ - $ -
$ - $ - $ -
$ 20,000 $ 18,000 $ -
$ 3,000 $ - $ -
$ 17,000 $ 18,000 $ -
$ 6,800 $ 7,200 $ -
$ 10,200 $ 10,800 $ -
$ 3,000 $ - $ -
$ 13,200 $ 10,800 $ -

Incremental
$ 14,440
$ 22,600
$ 18,080
$ 17,880
$ 20,280
$ 2,200

$20.280
$31.600
$17.880 $51.880

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