CHAPTER 9 - CAPITAL BUDGETING TECHNIQUE

1. You are a financial analyst for Damon Electronics Company. The director of capital
budgeting has asked you to analyze two proposed capital investments, Project X and Y.
Each project has a cost of $10,000, and the required return for each project is 12
percent. The projects’ expected cash flows are as follows:
Expected net cash flows
Year Project X Project Y
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

a) Calculate each project’s traditional payback period, net present value (NPV), internal rate
of return (IRR), modified internal rate of return (MIRR), and Discounted Payback Period
(DPB).
b) Which project or projects should be accepted if they are independent?
c) Which project should be accepted if they are mutually exclusive?

Answer (a):

Payback Period (PB):

Project X Project Y
Year Cash Flow Cumulative CF Cash Flow Cumulative CF
0 ($ 10,000) ($ 10,000) ($ 10,000) ($ 10,000)
1 6,500 (3,500) 3,500 (6,500)
2 3,000 (500) 3,500 (3,000)
3 3,000 2,500 3,500 500
4 1,000 3,500 3,500 4,000

500×12
Paybackx = 2 + = 2 year 2 months
3000

3000×12
Paybacky = 2 + = 2 year 10.28 months
3500
Net Present Value (NPB):

NPVX = - Initial Investment + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= - $ 10,000 + $ 6,500/(1.12) + $ 3,000/(1.12)2+ $ 3,000/(1.12)3+ $ 1,000/(1.12)4

= $ 966

NPVY = - Initial Investment + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= - $ 10,000 + $ 3500/(1.12) + $ 3500/(1.12)2+ $ 3500/(1.12)3+ $ 3500/(1.12)4

= $ 631

Discounted Payback Period (PB):

Project X Project Y
Year Cash Flow 12%PVIF Cumulative CF Cash Flow 12%PVIF Cumulative CF
0 ($10,000) ($10,000) ($10,000) ($10,000) ($10,000) ($10,000)
1 $6,500 $5,804 ($4,196) $3,500 $3,125 ($6,875)
2 $3,000 $2,392 ($1,805) $3,500 $2,790 ($4,085)
3 $3,000 $2,135 $330 $3,500 $2,491 ($1,594)
4 $1,000 $636 $966 $3,500 $2,224 $630

$1,805×12
PBDiscX = 2 + = 2 year 10.15 months
$2,135

$1,594×12
PBDiscY = 3 + = 3 year 8.6 months
$2,224

Answer (b):
Note that all methods rank project X over project Y. In addition, both projects are acceptable
under the NPV and PBDiscX criteria. Thus Both project should be accepted if they are
independent.

Answer (c):
In this case, we would choose the project with the higher NPV at r = 12%, or project X.
Magee computers makes bulk purchases of small computers, stocks them in conveniently
located warehouses, and ships them to its chain of retail stores. Magee’s balance sheet as of
December 31, 2009, is shown here ($ Millions):

Cash $3.5 Accounts payable $ 9.0

Receivables 26.0 Notes payable Accruals 18.0
Inventories 58.0 Accruals 8.5
Total Current Assets 87.5 Total Current Liabilities $ 35.5
Net Fixed assets 35.0 Long-term bonds 6.0
Common stock 15.0
Retained earnings 66.0
Total Assets $122.5 Total Liabilities and Equity $ 122.5

Sales for 2009 were $350 million, while net income for the year was $10.5 million. Magee paid
dividends of $4.2 million to common stockholders. The firm is operating at full capacity.
Assume that all the ratios remain constant. If sales are projected to increase by 70 million, or 20
percent, during 2005, use the Additional Funds Needed equation to determine Magee’s projected
external capital requirements. Assume Magee’s profit margin and dividend payout ratio remain
constant.

Construct Magee’s pro forma balance sheet for December 31, 2010. Assume that all external
capital requirements are met by bank loans and are reflected in notes payable. Assume Magee’s
profit margin and dividend payout ratio remain constant. Do not consider any financing feedback
effects.
Solution:
Magee Computers
Pro Forma Income Statement
Forecast Pro Forma
2009
Basis 2010

Sales $ 350 20% $ 420

Net income $ 10.5 $ 12.6
Dividends $ 4.2 $ 5.04
Add. Retain Earning $ 6.3 $ 7.56

2009 2010
Profit Margin Ratio = 0.03
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞
=> = 𝟎. 𝟎𝟑
𝐒𝐚𝐥𝐞𝐬
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞 𝟏𝟎.𝟓
Profit Margin Ratio = 𝐒𝐚𝐥𝐞𝐬
= 𝟑𝟓𝟎
= 𝟎. 𝟎𝟑 𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞
=> = 𝟎. 𝟎3
$ 𝟒𝟐𝟎

=> 𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞 = $𝟒𝟐𝟎 × 𝟎. 𝟎𝟑 = $ 𝟏𝟐. 𝟔

Dividend Payout Ratio = 0.04

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
=> = 𝟎. 𝟎𝟒
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝟒.𝟐
Dividend Payout Ratio = = = 𝟎. 𝟎𝟒 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞 𝟏𝟎.𝟓 => = 𝟎. 𝟎𝟒
𝟏𝟐.𝟔

=> 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 = $ 𝟏𝟐. 𝟔 × 𝟎. 𝟎𝟒 = $ 𝟓. 𝟎𝟒

Magee Computers
Pro Forma Balance Sheet
Forecast
2009 Pro Forma 2010
Basis
Cash $ 3.5
Receivables 26.0
Inventories 58.0
Total Current Assets 87.5
Net Fixed Assets 35.0
Total Assets $ 122.5 20% $ 147
Accounts payable $ 9.0 20% $ 10.8
Notes payable 18.0 18
Accruals 8.5 20% 10.2
Total current liabilities $ 35.5 $ 39
Long-term bonds 6.0 6.0
Total Debt. $ 41.5 $ 45
Common stock 15.0 15
Retained earnings 66.0 + 7.56 73.56
Total Liabilities and Equity $ 122.5 $ 147
AFN ($ 147 – 133.56) 13.44
Following are Noso Textiles 2009 financial statements.

Noso Textiles: Balance Sheet as of December 31, 2009 ($ Thousands)

Cash $ 1,080Accounts payable $ 4,320
Receivables 6,480Accruals 2,880
Inventories 9,000Notes payable 2,100
Total Current Assets $16,560 Total current liabilities $ 9,300
Net Fixed Assets 12,600 Long-term bonds 3,500
Common stock 3,500
Retained earnings 12,860
Total Assets $29,160 Total Liabilities and Equity $29, 160

Noso Textiles: Income Statement for December 31, 2009 ($ Thousands)

Sales $ 36,000
Operating costs (32,440)
Earnings before interest and taxes $ 3,560
Interest (560)
Earnings before Taxes $ 3,000
Taxes (40%) (1,200)
Net income $ 1,800
Dividends (45%) $ 810
Addition to retained earnings $ 990

a) Suppose 2010 sales are projected to increase by 15 percent over 2009 sales. Determine
the additional funds needed. Assume that the company was operating at fill capacity in
2009, that it cannot sell of any of its fixed assets, and that any required financing will be
borrowed as notes payable. Also, assume that assets, spontaneous liabilities, and
operating costs are expected to increase by the same percentage as sales. Use the
projected balance sheet method to develop a pro forma balance sheet and income
statement for December 31, 2010. (Do not incorporate any financing feedback effects.
Use the pro forma income statement to determine the addition to retained earnings.)
b) Use the financial statements developed in part a to incorporate the financing feedback as
a result of the addition to notes payable. (That is, do the next financial statement
iteration.) For the purpose of this part, assume that the notes payable interest rate is 10
percent. What is the AFN for this iteration?
Solution:
Noso Textiles
Pro Forma Income Statement
Forecast Pro Forma
2009
Basis 2010

Sales $ 36,000 15% $ 41,400

Operating costs (32,440) 15% (37,306)
Earnings before interest and taxes $ 3,560 $ 4,094
Interest (560) (560)
Earnings before taxes $ 3,000 $ 3,534
Taxes (40%) (1,200) (1,414)
Net income $ 1,800 $ 2,120
Dividends (45%) $ 810 $ 954
Add. Retain Earning $ 990 $ 1,166

Noso Textiles
Pro Forma Income Balance Sheet
Forecast
2009 Pro Forma 2010
Basis
Cash $ 1,080
Receivables 6,480
Inventories 9,000
Total Current Assets $16,560
Net Fixed Assets 12,600
Total Assets $29,160 15% $ 33,534
Accounts payable $ 4,320 15% $ 4,968
Accruals 2,880 15% 3,312
Notes payable 2,100 2100
Total current liabilities $ 9,300 $ 10,380
Long-term bonds 3,500 3500
Total Debt. $12,800 $ 13,880
Common stock 3,500 3,500
Retained earnings 12,860 + 1,166 14,026
Total Liabilities and Equity $29, 160 $ 31,406
AFN ($ 33,534 – 31,406) $2,128
The 2009 balance sheet and income statement for the woods company are shows here:

Woods Company: Balance Sheet as of December 31, 2009 ($ Thousands)

Cash $ 80 Accounts payable $ 160
Receivables 240 Accruals 40
Inventories 720 Notes payable 252
Total Current Assets $1,040 Total current liabilities $ 400
Net Fixed Assets 3,200 Long-term bonds 1,244
Common stock 1605
Retained earnings 939
Total Assets $4,240 Total Liabilities and Equity $4,240

Woods Company: Income Statement for December 31, 2009 ($ Thousands)

Sales $ 8,000
Operating costs (7,450)
Earnings before interest and taxes $ 550
Interest (150)
Earnings before taxes $ 400
Taxes (40%) (160)
Net income $ 240
Per Share Data
Common stock price $ 16.96
Earnings per share $ 1.60
Dividends per share $ 1.04

a) The firm operated full capacity at 2009. It expects sales to increase by 20 percent during
2010 and expects 2010 dividends per share to increase to $1.10. Use the projected
balance sheet method to determine how much outside financing is required, developing
the firm’s pro forma much outside financing is required, developing the firm’s pro forma
balance sheet and income statement, and use AFN as the balance items.
b) If the firm must maintain a current ratio of 2.3 and a debt ratio of 40 percent, how much
financing, after the first pass, will be obtained using notes payable, long term debt, and
common stock?
c) Construct the second-pass financial statements incorporating financing feedbacks, using
the ratio in part b. Assume that the interest rate on debt averages 10 percent.
Solution:
Woods Company
Pro Forma Income Statement
2009 Forecast Basis Pro Forma 2010
Sales $ 8,000 20% $ 8,000
Operating costs (7,450) 20% (7,450)
Earnings before interest and taxes $ 550 $ 550
Interest (150) (150)
Earnings before taxes $ 400 $ 400
Taxes (40%) (160) (160)
Net income $ 240 $ 240
Dividends 1.04*150 $ 156 1.1*150 $ 165
Add. Retain Earning $ 84 $ 141

No. of Share = 240/1.6 = 150

Woods Company
Pro Forma Balance Sheet
Forecast Pro Forma AFN
2009
Basis 2010 Effect
Cash $ 80 $ 96 $ 96
Receivables 240 288 288
Inventories 720 864 864
Total Current Assets $1,040 $1,248 $1,248
Net Fixed Assets 3,200 3,840 3,840
Total Assets $4,240 20% $5,088 $5,088
Accounts payable $ 160 20% 192 192
Accruals 40 20% 48 48
Notes payable 252 252 + 51 303
Total current liabilities $ 400 $ 492 $ 543
Long-term bonds 1,244 1,244 +248 1,492
Total Debt. $ 1,696 $ 1,736 $ 2,035
Common stock 1605 1605 +368
Retained earnings 939 +141 1,080 -42 1,038
Total Liabilities and Equity $4,240 $4,421 $5,046
AFN $ 667 $ 42
Cumulative AFN $ 667 $ 709

**CA/CL = 2.3; D/A = 40%.

Maximum total debt = 0.4* $5,088 = $2,035.
Maximum increase in debt = $2,035 - $1,736 = $299.
Maximum current liabilities = $1,248/2.3 = $543.
Increase in notes payable = $543 - $492 = $51.
Increase in long-term debt = $299 - $51 = $248.
Increase in common stock = $667 - $299 = $368.