Capital Budgeting Exercise

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.

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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%.
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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)
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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... [continues]

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