Slide 2 Capital Budgeting Problem Examples Please click on the
speaker icon on each slide to hear my explanation of how the
problem can be solved. Slide 3 Example One A New Investment After
the long drought of 1992, the manager of Long Branch Farm is
considering the installation of an irrigation system. The system
has an invoice price of $100,000 and will cost an additional
$15,000 to install. It is estimated that it will increase revenues
by $20,000 annually, although operating expenses other than
depreciation will also increase by $5,000. The system will be
depreciated straight-line over its depreciable life (5 years) to a
zero salvage value. The system can actually be sold for an
estimated $25,000 at the end of 5 years. If the tax rate on
ordinary income is 40 percent and the firms required rate of return
is 16 percent. Should the firm purchase the new system? Slide 4
Long Branch Farms - 2 CF 0 -100,000 Cost of System -15,000 Cost of
Installation -15,000 Cost of Installation -$115,000 Initial
Investment Slide 5 CF 1-5 Operating Cash Flows (20,000
5,000)(1-.40) + 23000(.40) =$18,200 =$18,200 Long Branch Farms - 3
Slide 6 Long Branch Farms - 4 CF 5T Terminal Cash Flows
25,000Salvage Value 25,000Salvage Value -10,000Tax on Gain $15,000
NPV = -$48,266IRR = -2.43% Slide 7 Example Two A Replacement
Problem International Soup Company is considering replacing a
canning machine. The old machine is being depreciated by the
straight-line method over a 10-year recovery period from a
depreciable cost basis of $120,000. The old machine has 5 years of
remaining usable live, at which time its salvage value is expected
to be zero, and it can be sold now for $40,000. This machine has a
current book value of $60,000. The purchase price of the new
machine is $250,000 and it will have shipping and installation
costs of $12,500. It has a 5-year life and an expected salvage
value of $25,000. Annual savings of electricity, labor and
materials from use of the new machine are estimated at $40,000. The
new machine will require an additional inventory of spare parts of
$30,000. The company is in a 40 percent tax bracket, and its cost
of capital is 16 percent. The machine will be depreciated straight
line over its five-year life. What should the firm do? Slide 8
International Soup - 2 CF 0 Initial Cash Flow -$250,000 Purchase
Price of New -12,500Installation -12,500Installation +40,000Sale of
Old Equipment +40,000Sale of Old Equipment +8,000 Tax Effect of
Sale +8,000 Tax Effect of Sale -30,000Working Capital
-30,000Working Capital -$244,500Initial Investment Slide 9
International Soup - 3 CF 1-5 Operating Cash Flows (40,000)(1-.40)
+ (40,500)(.40) = 24,000 + 16,200 = $40,200 Slide 10 International
Soup - 4 CF 5T Terminal Cash Flow +25,000Salvage Value of New
Equipment -10,000Tax Effect on Gain +30,000Recoup Working Capital
$45,000Terminal Cash Flow NPV = -$91,448IRR = 0.18% Slide 11
Example Three EAA / EAC Sony Corporation is considering the
purchase of a new phone system for a sales office in Boise, Idaho.
The Lucent Technologies system costs $54,000, has annual operating
expenses of $4,000 and an expected life of 9 years. The Toshiba
system has a cost of $48,000, annual operating expenses of $4,000
and an expected life of 7 years. Ignoring depreciation and taxes
and assuming a cost of capital of 9 percent for such an investment,
which system should Sony purchase? You are free to use either
replacement chain or EAA/EAC analysis. Slide 12 Lucent / Toshiba -
2 Estimate the CFs for each time period Estimate the CFs for each
time period Find the NPV of the CFs at the appropriate discount
rate clear calculator. Find the NPV of the CFs at the appropriate
discount rate clear calculator. Enter the NPV of the CFs as PV, the
life of the asset as N, and the discount rate as I. Enter the NPV
of the CFs as PV, the life of the asset as N, and the discount rate
as I. Solve for PMT and that is the EAA / EAC. Solve for PMT and
that is the EAA / EAC. Slide 13 Lucent / Toshiba - 3 Lucent: CF 0 =
-$54,000 CF 1-9 = -$4,000 NPV = -$77,981EAA/EAC = -$13,007
Toshiba:CF0 = -$48,000 CF1-7 = -$4,000 NPV = -$68,132EAA/EAC =
-$13,537 Slide 14 The End I hope this helped. Please dont hesitate
to call or email with any questions. Bruce
