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Chapter # 13 Capital Budgeting Techniques Problem # 1 Pay Back Period

The document contains examples of capital budgeting techniques including: 1) Payback period calculations for two projects (Project A and B) with Project B having a shorter payback period of 2.25 years compared to Project A's 2 years. 2) Net present value and profitability index calculations for Projects A and B showing Project B has a higher NPV of $1,394 and PI of 1.116, making it the preferred project. 3) More detailed calculations of payback period, NPV, and PI for two new projects (Projects A and B) with Project B again found to be preferable based on higher NPV and PI. 4) A multi-step example calculation

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181 views12 pages

Chapter # 13 Capital Budgeting Techniques Problem # 1 Pay Back Period

The document contains examples of capital budgeting techniques including: 1) Payback period calculations for two projects (Project A and B) with Project B having a shorter payback period of 2.25 years compared to Project A's 2 years. 2) Net present value and profitability index calculations for Projects A and B showing Project B has a higher NPV of $1,394 and PI of 1.116, making it the preferred project. 3) More detailed calculations of payback period, NPV, and PI for two new projects (Projects A and B) with Project B again found to be preferable based on higher NPV and PI. 4) A multi-step example calculation

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Sulman Haider
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Chapter # 13

Capital Budgeting Techniques

Problem # 1

Pay Back Period


Project A
Year 0 1 2 3
Cash Flows (9,000) 5,000 4,000 3,000
Cummulative Inflows$ 5,000 9,000 12,000
PBP a + (b - c) / d
2 + (9,000 - 9,000) / 3,000
2 Years

Project B
Year 0 1 2 3
Cash Flows (12,000) 5,000 5,000 8,000
Cummulative Inflows$ 5,000 10,000 18,000
PBP a + (b - c) / d
2 + (12,000 - 10,000) / 8,000
2.25 Years

Net Present Value


Project A
Year 0 1 2 3 NPV
Cash Flow (9,000) 5,000 4,000 3,000
PVIF(15%, 3) 1 0.870 0.756 0.658
Present Value $ (9,000) 4,350 3,024 1,974 348

Project B
Year 0 1 2 3 NPV
Cash Flow (12,000) 5,000 5,000 8,000
PVIF(15%, 3) 1 0.870 0.756 0.658
Present Value $ (12,000) 4,350 3,780 5,264 1,394
* NPV = Present value of Future Inflows - Initial Cash Outflows

Profitability Index
Project A
Year 0 1 2 3 PI
Cash Flow (9,000) 5,000 4,000 3,000
PVIF(15%, 3) 1 0.870 0.756 0.658
Present Value (9,000) 4,350 3,024 1,974 1.039
9,000
Project B
Year 0 1 2 3 PI
Cash Flow (12,000) 5,000 5,000 8,000
PVIF(15%, 3) 1 0.870 0.756 0.658
Present Value (12,000) 4,350 3,780 5,264 1.116 12000
* PI = Present Value of future Inflows/ Initial Cash Outflow

Project B is having greater NPV and PI so we will accept project B

Problem # 2

Project A
Savings 8,000 8,000 8,000 8,000 8,000 8,000 8,000
Less: Depreciation* (5,600) (8,960) (5,376) (3,226) (3,225) (1,613) 0
Change in Income before
taxes 2,400 (960) 2,624 4,774 4,775 6,387 8,000
Less:Taxes (34%) (816) 326 (892) (1,623) (1,624) (2,172) (2,720)
Change in income after
tax 1,584 (634) 1,732 3,151 3,151 4,215 5,280
Add: Depreciation 5,600 8,960 5,376 3,226 3,225 1,613 0
Net Cash Flow 7,184 8,326 7,108 6,377 6,376 5,828 5,280
* Depreciation = 28,000 * MACRS Rates

Project B
Savings 5,000 5,000 6,000 6,000 7,000 7,000 7,000
Less: Depreciation* (4,000) (6,400) (3,840) (2,304) (2,304) (1,152) 0
Change in Income before
taxes 1,000 (1,400) 2,160 3,696 4,696 5,848 7,000
Less:Taxes (34%) (340) 476 (734) (1,257) (1,597) (1,988) (2,380)
Change in income after
tax 660 (924) 1,426 2,439 3,099 3,860 4,620
Add: Depreciation 4,000 6,400 3,840 2,304 2,304 1,152 0
Net Cash Flow 4,660 5,476 5,266 4,743 5,403 5,012 4,620
* Depreciation = 20,000 * MACRS Rates

Pay Back Period


Project A
Year 0 1 2 3 4 5 6
Cash Flows (28,000) 7,184 8,326 7,108 6,377 6,376 5,828
Cummulative Inflows 7,184 15,510 22,618 28,995 35,371 41,199
PBP a + (b - c) / d
3 + {(28,000 - 22,618) / 6,377}
3.84 Years

Project B
Year 0 1 2 3 4 5 6
Cash Flows (20,000) 4,660 5,476 5,266 4,743 5,403 5,012
Cummulative Inflows 4,660 10,136 15,402 20,145 25,548 30,560
PBP a + (b - c) / d
3 + {(20,000 - 15,402) / 4,743}
3.97 Years

Net Present Value


Project A
Year 0 1 2 3 4 5 6
Cash Flows (28,000) 7,184 8,326 7,108 6,377 6,376 5,828
PVIF(14%, 7) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present Value (28,000) 6,300 6,403 4,798 3,775 3,309 2,658

Project B
Year 0 1 2 3 4 5 6
Cash Flows (20,000) 4,660 5,476 5,266 4,743 5,403 5,012
PVIF(14%, 7) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present Value (20,000) 4,087 4,211 3,555 2,808 2,804 2,285
* Net Present Value (NPV) = Present value of Future Inflows - Initial Cash Outflows

Profitability Index
Project A
Year 0 1 2 3 4 5 6
Cash Flows (28,000) 7,184 8,326 7,108 6,377 6,376 5,828
PVIF(14%, 7) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present Value (28,000) 6,300 6,403 4,798 3,775 3,309 2,658

Project B
Year 0 1 2 3 4 5 6
Cash Flows (20,000) 4,660 5,476 5,266 4,743 5,403 5,012
PVIF(14%, 7) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present Value (20,000) 4,087 4,211 3,555 2,808 2,804 2,285
* Profitability Index (PI) = Present Value of future Inflows/ Initial Cash Outflow

As Project B is having greater NPV and PI so Project B should be selected.

Problem # 3

Step A
Estimating Initial Cash OutFlow
(a) 60,000 (Cost of new Asset)
(b) + 0 (Capital expenditure)
(c) + 0 (Increase in Net Working Capital)
(d) - 0 (Proceed from sale of old asset)
(e) + 0 (Taxes due to sale of old asset)
(f) 60,000 (Initial Cash outflow)
========

Step B
Interim Incremental Net Cash Flow
Year 1 Year 2 Year 3 Year 4 Year 5
(a) Savings 20,000 20,000 20,000 20,000 20,000
(b) - Depreciatio (19,998) (26,670) (8,886) (4,446) 0

Change in
Income
before
(c) = taxes 2 (6,670) 11,114 15,554 20,000
(d) - Taxes (38%) (1) 2,535 (4,223) (5,911) (7,600)

Change in
Income
(e) = after taxes 1 (4,135) 6,891 9,643 12,400
(f) + Depreciatio 19,998 26,670 8,886 4,446 0
Net Cash
(g) = Flow 19,999 22,535 15,777 14,089 12,400
=========================================
Step 3
Terminal Year Incremental Net Cash Flow
(a) 12,400 (Incremental Cash Flow of Year 5 through Step B)
(b) + 0 (Salvage Value)
(c) - 0 (Taxes due to sale of new asset)
(d) + 0 (Decrease in Net Working Capital)
(e) 12,400 (Terminal Year Incremental Net Cash Flow)
========

Expected Cash Flows are:


Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
(60,000) 19,999 22,535 15,777 14,089 12,400

Net Present Value

Year 0 1 2 3 4 5 NPV
Cash Flows (60,000) 19,999 22,535 15,777 14,089 12,400
PVIF(15%, 5) 1 0.870 0.756 0.658 0.572 0.497
Present Value (60,000) 17,399 17,036 10,381 8,059 6,163 (961)

As NPV is negative so project is not acceptable

Problem # 4

Step A
Estimating Initial Cash OutFlow
(a) 60,000 (Cost of new Asset)
(b) + 0 (Capital expenditure)
(c) + 0 (Increase in Net Working Capital)
(d) - 0 (Proceed from sale of old asset)
(e) + 0 (Taxes due to sale of old asset)
(f) 60,000 (Initial Cash outflow)
========

Step B
Interim Incremental Net Cash Flow
Year 1 Year 2 Year 3 Year 4 Year 5
(a) Savings 20,000 21,200 22,472 23,820 25,250
(b) - Change in
Depreciatio (19,998) (26,670) (8,886) (4,446) 0
Income
before
(c) = taxes 2 (5,470) 13,586 19,374 25,250
(d) - Increase in (1) 2,079 (5,163) (7,362) (9,595)

Change in
Income
(e) = after taxes 1 (3,391) 8,423 12,012 15,655
(f) + Depreciatio 19,998 26,670 8,886 4,446 0
Net Cash
(g) = Flow 19,999 23,279 17,309 16,458 15,655
========================================

Step 3
Terminal Year Incremental Net Cash Flow
(a) 15,655 (Incremental Cash Flow of Year 5 through Step B)
(b) + 0 (Salvage Value)
(c) - 0 (Taxes due to sale of new asset)
(d) + 0 (Decrease in Net Working Capital)
(e) 15,655 (Terminal Year Incremental Net Cash Flow)
========

Expected Cash Flows are:


Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
(60,000) 19,999 23,279 17,309 16,458 15,655

Net Present Value

Year 0 1 2 3 4 5 NPV
Cash Flows (60,000) 19,999 23,279 17,309 16,458 15,655
PVIF(15%, 5) 1 0.870 0.756 0.658 0.572 0.497
Present Value (60,000) 17,399 17,599 11,389 9,414 7,781 3,582

Now NPV is positive so project is acceptable


7
5,280
46,479

7
4,620
35,180

7 NPV*
5,280
0.4
2,112 1,355

7 NPV*
4,620
0.4
1,848 1,598

7 PI*
5,280
0.4
2,112 1.05

7 PI*
4,620
0.4
1,848 1.08

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