Solutions to Capital Budgeting Problems

Capital Budgeting Handout

3 Expansion Problems

Ellis Construction Company

T = 0 Initial Investment

Buy and modify equipment (60,000)

Change in NWC (2,000)

Total Initial Investment (62,000)

T = 1-3 Operations

Year 1 Year 2 Year 3

Inc. EBIT 20,000 20,000 20,000
Depreciation (19,800) (27,000) (9000)
Taxable Income 200 (7,000) 11,000
NOPAT 120 (4,200) 6,600
+ Depreciation 19,800 27,000 9,000
CF from Operations 19,920 22,800 15,600

T = 3 Termination

Sell the equipment 20,000

(6,320)
MV = 20,000
BV = 4,200
Gain 15,800
*T *.40
(6,320)

Reverse the Change in NWC 2,000

Total Cash Flow from Termination 15,680

NOTE: The depreciation amounts are from the MACRS 3-yr schedule [ yr. 1 = 33%, Yr.
2 = 45%, Yr. 3 = 15%, Yr. 4 = 7%] multiplied by the depreciable cost of the equipment.
Timeline
Year 0 1 2 3
CF (62,000) 19,920 22,800 15,600
15,680
TOTAL (62,000) 19,920 22,800 31,280
NPV = (1546.81)
IRR = 8.68%
MIRR = 9.08%
Payback Period = 2.62 years
Discounted Payback Period = never pays back on a discounted basis.

_____________________________________________________________

2nd Capital Budgeting Problem

T = 0 Initial investment

Buy and modify equipment (170,000)

Change in Net working Capital (8,000)

Total Initial Investment (178,000)

T = 1-3 Operations

Year 1 Year 2 Year 3

Inc. EBIT 50,000 50,000 50,000
Depreciation (53,333) (53,333) (53,333)
Taxable Income (3,333) (3,333) (3,333)
NOPAT (1,999.8) (1,999.8) (1,999.8)
+ Depreciation 53,333 53,333 53,333
CF from Operations 51,333 51,333 51,333

T = 3 Termination

Sell the equipment 60,000

(20,000)
MV = 60,000
BV = 10,000
Gain 50,000
*T *.40
(20,000)

Reverse the Change in NWC 8,000

Total Cash Flow from Termination 48,000

NOTE: The depreciation amounts are from using the straight line method and
depreciating over three years toward a 10,000 salvage value [170,000 – 10,000 divided
by 3 = 53,333].
Timeline
Year 0 1 2 3
CF (178,000) 51,333 51,333 51,333
48,000
TOTAL (178,000) 51,333 51,333 99,333

NPV = (20,541.34)
IRR = 5.87%
MIRR = 7.51%
Payback Period = 2.76 years
Discounted Payback Period = never pays back on a discounted basis

3rd Capital Budgeting Problem - Brauer

T = 0 Initial investment

Buy and modify equipment (120,500)

Change in Net working Capital (5,500)

Total Initial Investment (126,000)

T = 1-3 Operations

Year 1 Year 2 Year 3

Inc. EBIT 44,000 44,000 44,000
Depreciation (39,765) (54,225) (18,075)
Taxable Income 4,235 (10,225) 25,925
NOPAT 2,795 (6,748) 17,110
+ Depreciation 39,765 54,225 18,075
CF from Operations 42560 47,477 35,185

T = 3 Termination

Sell the equipment 65,000

(19,232)
MV = 65,000
BV = 8,435
Gain 56,565
*T *.34
19,232

Reverse the Change in NWC 5,500

Total Cash Flow from Termination 51,268

NOTE: The depreciation amounts are from the MACRS 3-yr schedule [ yr. 1 = 33%, Yr.
2 = 45%, Yr. 3 = 15%, Yr. 4 = 7%] multiplied by the depreciable cost of the equipment.
Timeline
Year 0 1 2 3
CF (126,000) 42,560 47,477 35,185
51,268
TOTAL (126,000) 42,560 47,477 86,453

NPV = 11,383.83
IRR = 16.58%
MIRR = 15.28%
Payback Period = 2.42 years
Discounted Payback Period = 2.82 years

Replacement Problems
Dauten Toy

T= 0 Initial Investment

Buy the new machine (8,000)

Change in NWC (1,500)

Sell the old machine 3,000

(160)
MV = 3000
BV = 2600
Gain = 400
*T *.4
Tax 160 _______
Total Initial Investment (6,660)

T = 1-6 Operations

1 2 3 4 5 6
Sales increase 1,000 1,000 1,000 1,000 1,000 1,000
Cost decrease (1,500) (1,500) (1,500) (1,500) (1,500) (1,500)
Change in EBIT 2,500 2,500 2,500 2,500 2,500 2,500
[line 1-2]
Change in 1,250 2,210 1,170 610 530 130
Depreciation
Taxable Income 1,250 290 1,330 1,890 1,970 2,370
[line 3-4]
NOPAT 750 174 798 1,134 1,182 1,422
+ Depreciation 1,250 2,210 1,170 610 530 130
CF from Operations 2,000 2,384 1,968 1,744 1,712 1,552
T=6 Termination

Net Salvage Cash Flow NEW Net Salvage Cash Flow OLD

Sell the new 800 Sell the old 500

(320)
MV = 800 MV = 500
BV = 0 BV = 500
Gain = 800 Gain = 0
*T *.4 no tax due
Tax 320

Rev. Change NWC 1,500

Net Salvage CF New 1,980 Net Salvage CF OLD 500

Difference 1980 – 500 = 1480 = the improved salvage value of the new over the old.

Timeline
Year 0 1 2 3 4 5 6
CF (6,660) 2,000 2,384 1,968 1,744 1,712 1,552
1480
TOTAL (6,660) 2,000 2,384 1,968 1,744 1,712 3032

NPV = 1334.89
IRR = 22.03%
MIRR = 18.56%
Payback Period = 3.18 years
Discounted Payback Period = 4.97 years

Yonan
T=O Initial Investment

Buy the new (150,000)

Change in NWC 1,000

Sell the old 65,000

(20,060)
MV = 65,000
BV = 6,000
Gain 59,000
*T *.34
Tax 20,060 __________
Total Initial Investment (104,060)
T = 1-5 Operations
1 2 3 4 5
Change in EBIT 50,000 50,000 50,000 50,000 50,000
Change in 24,000 48,000 28,500 18,000 16,500
Depreciation
Taxable Income 26,000 2,000 21,500 32,000 33,500
[line 1-2]
NOPAT 17,160 1,320 14,190 21,120 22,110
+ Depreciation 24,000 48,000 28,500 18,000 16,500
CF from Operations 41,160 49,320 42,690 39,120 38,610

T = 5 Termination

Net Salvage Cash Flow NEW Net Salvage Cash Flow OLD

Sell the new 0 Sell the old 10,000

3060 (3,400)
MV = 0 MV = 10,000
BV = 9,000 BV = 0
Loss = 9,000 Gain = 10,000
*T *.34 *T * .34
Tax 3,060 Tax 3,400
Credit

Rev. Change NWC (1,000)

Net Salvage CF New 2,060 Net Salvage CF OLD 6,600

Difference 2,060 – 6,600 = (4,540) = the loss of salvage value of the new over the old.

Timeline
Year 0 1 2 3 4 5
CF (104,060) 41,160 49,320 42,690 39,120 38,610
(4,540)
TOTAL (104,060) 41,160 49,320 42,690 39,120 34,070

Payback Period = 2.32 years

Discounted Payback Period = 3.21 years
NPV = 33,252.03
IRR = 29. 53%
MIRR = 22.61%
Baton Rouge

T= 0 Initial Investment

Buy the new machine (82,500)

Change in NWC (3,000)

Sell the old machine 30,000

(6,200)
MV = 30,000
BV = 14,500
Gain = 15,500
*T *.4
Tax 6,200 _______
Total Initial Investment (61,700)

T = 1-8 Operations

1 2 3 4 5 6 7 8
Change in EBIT 27,000 27,000 27,000 27,000 27,000 27,000 27,000 27,000
Change in 10,500 20,900 12,675 9,900 9,075 4,950 0 0
Depreciation
Taxable Income 16,500 6,100 14,325 17,100 17,925 22,050 27,000 27,000
[line 3-4]
NOPAT 9,900 3,660 8,595 10,260 10,755 13,230 16,200 16,200
+ Depreciation 10,500 20,900 12,675 9,900 9,075 4,950 0 0
CF from 20,400 24,560 21,270 20,160 19,830 18,180 16,200 16,200
Operations

T=8 Termination

Net Salvage Cash Flow NEW Net Salvage Cash Flow OLD

Sell the new 0 Sell the old 1,000

0 (400)
MV = 0 MV = 1,000
BV = 0 BV = 0
Gain =0 Gain = 1,000
no tax due *T _*.4
tax 400

Rev. Change NWC 3,000

Net Salvage CF New 3,000 Net Salvage CF OLD 600

Difference 3,000 – 600 = 2,400 = the improved salvage value of the new over the old.
Timeline
Year 0 1 2 3 4 5 6 7 8
CF (61,700) 20,400 24,560 21,270 20,160 19,830 18,180 16,200 16,200
2,400
TOT. (61,700) 20,400 24,560 21,270 20,160 19,830 18,180 16,200 18,600

Payback Period = 2.79 years

Discounted Payback Period = 3.68 years
NPV = 39,347.89
IRR = 29.48%
MIRR = 19.12%

McCullough
T=O Initial Investment

Buy the new (1,175,000)

Change in NWC 0

Sell the old 265,000

113,900
MV = 265,000
BV = 600,000
Loss 335,000
*T *.34
Tax 113,900 __________
Total Initial Investment (796,100)

T = 1-5 Operations
1 2 3 4 5
Change in EBIT 255,000 255,000 255,000 255,000 255,000
Change in 115,000 256,000 103,250 21,000 9,250
Depreciation
Taxable Income 140,000 (1,000) 151,750 234,000 245,750
[line 1-2]
NOPAT 92,400 (660) 100,155 154,440 162,195
+ Depreciation 115,000 256,000 103,250 21,000 9,250
CF from Operations 207,400 255,340 203,405 175,440 171,445

T = 5 Termination
Net Salvage Cash Flow NEW Net Salvage Cash Flow OLD

Sell the new 145,000 Sell the old 0

(25,330)
MV = 145,000 MV = 0
BV = 70,500 BV = 0
Gain = 74,500 Gain = 0
*T *.34 No tax due
Tax 25,330
Rev. Change NWC 0
Net Salvage CF New 119,670 Net Salvage CF OLD 0

Difference 119,670 - 0 = 119,670 = the increased salvage value of the new over the old.

Timeline
Year 0 1 2 3 4 5
CF (796,100) 207,400 255,340 203,405 175,440 171,445
119,670
TOTAL (796,100) 207,400 255,340 203,405 175,440 291,115

Payback Period = 3.74 years

Discounted Payback Period = 4.91 years
NPV = 14,095.48
IRR = 12.7%
MIRR = 12.39%