1. 1 Chapter 13-A Capital Budgeting M11-Chp-13-1A-Capital-Budget-2011-0525 Edited May 25, 2011. Copyright © 2011, Dr. Howard Godfrey This file contains illustrative problems that will be used in the lecture to illustrate important concepts and procedures. See separate PowerPoint file with review material on interest.

3. Introductory Exercise

4. Joe’s Package Delivery Service. Joe had started a package delivery service in Charlotte. He bought a truck at a cost of $20,000. The truck will have a 5-year life, and will have no salvage value after 5 years. Joe receives a salary of $30,000 and has other expenses of $10,000 for insurance, oil, gas, etc. Please fill in the blanks on next slide.

7. Review the problem on the preceding slides. Suppose revenue is only $44,000 per year. What is payback period? Would you recommend the project?

10. 1: Net present value

11. Present Value Problem - Bonkins On Jan 1, Bonkins Inc., bought for $520,000 a new machine with a useful life of 8 years & no salvage value. Machine will be depreciated using the straight-line method. It will produce annual cash flow from operations, net of income taxes, of $132,500. PV of an ordinary annuity of $1 for eight periods at 14% is 4.639. PV of $1 for eight periods at 14% is 0.351. Assume a time adjusted rate of return of 14%, what is the NPV? a. $ 36,680 b. $ 94,668 c. $154,440 d. $255,145

12. Present Value Problem - Bonkins

14. Hillsdale

15. PV Problem-Willsdale Willsdale purchased a machine for $480,000. The machine has a useful life of six years and no salvage value. Straight-line depreciation is used. The machine will generate cash flow from operations, net of income taxes, of $180,000 in each of the six years. Willsdale's desired rate of return is 14%. Information on present value factors is as follows: Period P. V. of $1 AT 14% 1.877 2.769 3.675 4.592 5.519 6.456 What would be the net present value? a. $63,840 b. $64,460 c. $219,840 d. $233,340

16. Garwood Garwood bought a machine which will be depreciated on the straight-line basis over an estimated useful life of 7 years and no salvage value. Machine will generate cash flow from operations, net of income taxes, of $80,000 in each of the 7 years Garwood's expected rate of return is 12%. Information on present value is: P.V. of $1 at 12% for 7 periods0.452 P.V. of annuity of $1 at 12% for 7 periods4.564 Assuming a positive net present value of $12,720, what was the machine's cost? a. $240,400 b. $253,120 c. $352,400 d. $377,840

17. 2: Internal rate of return

19. Rott Rott is considering investing $130,000 in 10-year project. Rott estimates that the annual cash in flow, net of income taxes, from this project will be $20,000. Rott's desired rate of return on investment of this type is 10%. Information on present value factors is as follows: At 10%At 12% P V of $1 for ten periods 0.3680.322 P V of annuity of $1 for ten periods6.1455.650 Rott's excepted rate of return on this investment is: a. Less than 10%, but more than 0% b. 10%. c. Less than 12%, but more than 10%. d. 12%.

21. 3: Uncertain cash flows

22. 4: Preference ranking

23. 5: Payback

24. Payback Model Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P= I ÷ O [P= I ÷ Cash flow]

25. Payback Model Example Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. Annual savings of $4,000 in cash outflows are expected from operations. What is the payback period? P = I ÷ O = $12,000 ÷ $4,000 = 3 years

26. Payback Problem Which of these is necessary to calculate the pay-back period for a project? a. Useful life. b. Minimum desired rate of return. c. Net present value. d. Annual cash flow

27. Note. In the following question, you are given the net amount of cash from the project, after subtracting expenses and income taxes. In later problems, you must compute taxable income, so you will know how much cash is spent for income taxes. Of course, tax payments are cash outflows.

28. Payback Problem-Womark Womark Co. bought a new machine on January 1, for $90,000 with an estimated useful life of five years and a salvage value of $0. The machine will be depreciated using the straight-line method. The machine is expected to produce cash flow from operations, net of income taxes, of $22,500 a year in each of the next five years. The payback period will be: a. 2.2 years. b. 2.5 years. c. 4.0 years. d. 4.5 years.

29. Payback Problem-Womark

31. In the next few problems, you must compute taxable income, so you will know how much cash is spent for income taxes. Of course, tax payments are cash outflows.

32. Payback-Monroe Monroe is planning to purchase a new machine for $500,000. The new machine is expected to produce cash flow from operations, before income taxes, of $155,000 a year in each of the next five years. Depreciation of $100,000 year will be charged to income for each of the next five years. The income tax rate is 40%. The payback period is approximately a. 2.2 years b. 3.4 years c. 3.7 years d. 4.1 years

35. Payback Problem-Gravina Gravina plans to spend $6,000 for machine which it will depreciate on a straight-line basis over a ten-year period. The machine will generate additional cash revenues of $2,400 a year. Gravina will incur no additional costs except for depreciation and income tax. The income tax rate is 50%. What is the pay-back period? a. 3.3 years b. 4.0 years c. 5.0 years d. 6.7 years

36. Payback Problem-Gravina

38. 6: Simple rate of return

39. Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment.

40. Accounting Rate-of-Return Model Assume the following: Investment is $6,075. Useful life is four years. Estimated disposal value is zero. Expected annual cash inflow from operations is $2,000. What is the annual depreciation? Ignore Depreciation here.

41. Accounting Rate-of-Return $6,075 ÷ 4 = $1,518.75, (rounded to $1,519) (Deprec.) What is the ARR? ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

42. Acct Rate of Return - Saratoga Saratoga will purchase a new machine for $600,000. The new machine will be depreciated on the straight line basis over a 6 years, with no salvage, and a full year's depreciation is taken in the year of acquisition. The new machine will produce cash flow from operations, net of income taxes, of $200,000 a year in each of the next six years. The accounting (book value) rate of return on the initial investment will be a. 8.3% b. 12.0% c. 16.7% d. 25.0%

45. Apex Apex Company is evaluating a capital budgeting proposal. Relevant data follow: Year.............. 1 2 3 4 5 6 P. V. of Annuity of $1 at 15%.... $.8701.6262.2842.8563.3533.785 The initial investment would be $30,000. It would be depreciated on a straight- line basis over six years with no salvage value. The before tax annual cash flow due to this investment is $10,000, and the income tax rate is 40% paid in the same year as incurred. The desired rate of return is 15%. All cash flows occur at the end of the year. What is the net present value of this proposal? a. $(7,290) b. $280 c. $7,850 d. $11,860

46. Apex Refer to the preceding slide. What is the after tax accounting rate of return? a. 10% b. 16-2/3% c. 26-2/3% d. 33-1/3%

47. 8: Income tax

48. NPV after Tax- Studley On Jan. 1, Studley bought a new machine for $100,000 with an estimated useful life of five years and no salvage. For book and tax purposes, the machine will be depreciated using the straight line method and it is expected to produce annual cash flow from operations, before income taxes, of $40,000. Studley uses a time adjusted rate of 12% and its income tax rate will be 40% for all years. The present value of $1 at 12% for five periods is 0.57, and the present value of an ordinary annuity of $1 at 12% for five periods is 3.61. The NPV of the machine should be a. $15,520 positive b. $15,520 negative c. $14,000 positive d. $13,680 negative

52. Form for Capital Budgeting-1 This format (following slides) can be used for revenue and expenses for a proposed project. If the same depreciation method is used on both the books and the return, you only need to complete the first column. (Many capital budgeting problems allow you to assume that the same depreciation methods is used for both purposes.)

53. Form for Capital Budgeting-2

54. Form for Capital Budgeting-3

55. Gains or Losses on Disposal -1 Suppose a piece equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight- line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000

56. Assume that it is sold for $70,000 and the tax rate is 40%. What is the cash inflow? ($70,000 – $50,000) × 40% = $8,000 $70,000 – $8,000 = $62,000 Gains or Losses on Disposal - 2 Assume that it is sold for $70,000 and the tax rate is 40%. What is the cash inflow? ($70,000 – $50,000) × 40% = $8,000 $70,000 – $8,000 = $62,000

57. Gains or Losses on Disposal If it is sold for book value, there is no gain or loss and so there is no tax effect. If it is sold for more than $50,000, there is a gain and an additional tax payment. If it is sold for less than $50,000, there is a loss and a tax savings.

58. Combination of Problems-1 Items 1 through 4 are based on the following: Ram Co. is negotiating for the purchase of equipment that would cost $100,000. Ram expects that $25,000 per year could be saved in after ‑ tax cash costs if the equipment were acquired. The equipment's estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Ram's minimum desired rate of return is 12%. PV of an annuity of 1 at 12% for 10 periods: 5.65 PV of 1 due in 10 periods at 12%:.322

59. Combination of Problems-2 Continue from preceding slide. 1. The net present value is a. $ 41,250 b. $ 6,440 c. $12,200 d. $13,000 2. The payback period is a. 4.0 years. b. 4.4 years. c. 4.5 years. d. 5.0 years.

60. Combination of Problems-3 Continue from preceding slide. 3. The accrual accounting rate of return based on initial investment is a. 20% b. 15% c. 12% d. 10% 4. In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to the following multiple. a.0.65 b. 4.00 c. 5.00 d. 5.65

61. Combination of Problems

66. Hilltop Hilltop Company invested $100,000 in a two-year project. Hilltop's expected rate of return was 12%. The cash flow, net of income taxes, was $40,000 for the first year. Present value and future value factors are as follows: PeriodPresent value Future value of $1 at 12% 1.8929 1.1200 2.7972 1.2544 Assuming that the rate of return was exactly 12%, what was the cash flow, net of income taxes, for the second year of the project? a. $51,247 b. $60,000 c. $64,284 d. $80,638

67. Hilltop

68. The End 68