# Capital Budgeting Exercise

Pages: 8 (2001 words) Published: June 2, 2010
Corporate Finance
Capital Budgeting Exercises

Problem 1
ABC Industries is considering a proposed project whose estimated NPV is \$12 million. This estimate assume that economic conditions will be “average.” However, the CFO realizes that conditions could be better or worse, so he performed a scenario analysis and obtained these results: Economic Probability of Scenario Outcome NPV Recession 0.05 (\$70 million) Below Average 0.20 (\$25 million) Average 0.50 \$12 million Above Average 0.20 \$20 million Boom 0.05 \$30 million Calculate the project’s expected NPV, standard deviation, and 2 coefficient of variation.

Problem 1
E(NPV) = 0.05 (-\$70) + 0.20 (-\$25) + 0.50 (\$12) + 0.20 (\$20) + 0.05 (\$30) = -\$3.5 + -\$5.0 + \$6.0 + \$4.0 + \$1.5 = \$3.0 million.

σNPV

= [0.05(-\$70 – \$3)2 + 0.20(-\$25 – \$3)2 + 0.50(\$12 – \$3)2 + 0.20(\$20 – \$3)2 + 0.05(\$30 – \$3)2 ]½ = \$23.622 million.

3

Problem 2
You must evaluate a proposed spectrometer for the R&D department. The base price \$140000, and it would cost another \$30000 to modify the equipment for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3 years for \$60000. The applicable depreciation rates are 33, 45, 15, and 7 percent. The equipment would require an \$8000 increase in working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm \$50000 per year before-tax labor costs. The firm’s marginal tax is 40%. 4

Problem 2-A
A. What is the net cost of the spectrometer, that is what is the year 0 project cash flow? Cost of investment at t0: Base price Modification Increase in NOWC Cash outlay for new machine

(\$140000) (\$30000) (\$8000) (\$178000)
5

Problem 2-B
B. What are the net operating cash flows in years 1, 2, and 3? Year 1 After-tax savings \$30000 Depreciation tax savings 22440 Net operating cash flow \$52440 Year 2 \$30000 30600 \$60600 Year 3 \$30000 10200 \$40200

Notes: 1. The after-tax cost savings is \$50000 (1 – t) = \$50000 (0.6) = \$30000. 2. The depreciation expense in each year is the depreciable basis, \$170000, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is \$56100, \$76500, and \$25500. The depreciation tax savings is calculated as the tax rate (40%) times the depreciation expense in each year. 6

Problem 2-C
C. What is the terminal cash flow? Salvage value \$60000 Tax on SV* (\$19240) Return of NOWC \$8000 Terminal Value \$48760 *Tax on SV = (\$60000 – \$11900)(0.4) = \$19240. Remaining BV in Year 4 = \$170000 (0.07) = \$11900. 7

Problem 2-D
D. If the WACC is 12 percent, should the spectrometer be purchased? Year Net Cash Flow PV @ 12% 0 (\$178000) (\$178000) 1 52440 46821 2 60600 48310 3 88960 63320 NPV = (\$19549) The project has an NPV of (\$19549). Thus, it should not be accepted.

8

Problem 2-D
Alternatively, place the cash flows on a time line: 0 1 12% | | -178000 52440 3 | 40200 48760 88960 With a financial calculator, input the cash flows into the cash flow register, I/YR = 12, and then solve for NPV = -\$19548.65 ≈ -\$19549. IRR = 6.03%. 2 | 60600

9

Problem 3
You must evaluate a proposal to buy a new milling machine. The base price is \$108000, and shipping and installation costs would add another \$12500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for \$65000. The applicable depreciation rates are 33, 45, 15, and 7 percent. The machine would require a \$5500 increase in working capital (increased inventory less increased account payable). There would be no effect on revenues, but pre-tax labor costs would decline by \$44000 per year. The marginal tax rate is 35%, and WACC is 12 percent. Also, the firm spent \$5000 last year investigating the feasibility of using the machine.

10

Problem 3-A
A. How should the \$5000 spent last year be handled? The \$5000 spent last year on exploring the feasibility of the...