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%. 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)

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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 $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.

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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

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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.

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Problem 3-A

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

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