ACCY 122 Spring 2010

#A Delta Software

Solutions to Capital Budgeting Problems

Data
Equipment Cost

$75,000

Equipment Life

Interest Rate
Discount
Rate/WACC

This model assumes the normal

straight-line method of
depreciation.

0%

Data
Equipment Cost

$75,000

Equipment Life

Interest Rate
Discount
Rate/WACC

10%

This model assumes the tax method of

depreciation - MACRS. See table.

0%
10%

Year

Initial Outlay

0
($75,000
)

Year
2

0
Initial Outlay

($75,000)

Sales

$60,000

$60,000

$60,000

Sales

$60,000

$60,000

$60,000

$0

Operating costs

$25,000

$25,000

$25,000

Operating costs

$25,000

$25,000

$25,000

$0

Depreciation rate

33.33%

33.33%

33.33%

Depreciation rate

33.33%

44.45%

14.81%

7.41%

Depreciation

$25,000

$25,000

$25,000

Depreciation

$25,000

$33,338

$11,108

$5,558

Total expenses

$50,000

$50,000

$50,000

Total expenses

$50,000

$58,338

$36,108

$5,558

EBIT

$10,000

$10,000

$10,000

EBIT

$10,000

$1,663

$23,893

($5,558)

Taxes - 35%

$3,500

$3,500

$3,500

Taxes - 35%

$3,500

$582

$8,362

($1,945)

Net Income
Add back
depreciation
Operating cash
flow
PV of operating
cash flow
=PV(+B5,+B3,C18,0)

$6,500

$6,500

$6,500

$6,500

$1,081

$15,530

($3,612)

$25,000

$25,000

$25,000

$25,000

$33,338

$11,108

$5,558

$31,500

$31,500

$31,500

$31,500

$34,418

$26,638

$1,945

$28,636

$26,033

$23,666

Net Income
Add back
depreciation
Operating cash
flow
PV of operating
cash flow
=PV($H$5,I7,0,I18)

$28,636

$28,445

$20,013

$1,329

Bool-to-tax difference

$87

NPV of project

$78,336

$78,336
$3,336

=+B19+B8

ACCY122_Sp10_Notes_CapBud_KEY

NPV of project
=+H19+H8

$78,423

$3,423

ACCY 122 Spring 2010

Solutions to Capital Budgeting Problems

#B. The Movie Place is considering a new investment whose data are shown below. The required equipment has a 3-year tax life and
would be fully depreciated by the straight line method over the 3 years, but it would have a positive salvage value at the end of Year 3,
when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the
project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?
WACC
10%
Net equipment cost (depreciable basis)
$65,000
Required new working capital
$10,000
Straight line deprn rate
33.33%
Sales revenues
$70,000
Operating costs excl. deprn
$25,000
Expected pretax salvage value
$5,000
Tax rate
35%
answer: $26,553.97
Answer:
Investment in fixed assets
Investment in net working capital
Sales revenues
- Operating costs (x-depr)
- Basis x rate = depreciation =
Operating income (EBIT)
- Taxes
After-tax EBIT
+ Depreciation
Operating cash flow
Recovery of working capital
Salvage value, pre-tax
Tax on salvage value
Total cash flows
NPV
$26,553.97

t=0
-$65,000
-$10,000

t=1

t=2

t=3

-$75,000

$70,000
-$25,000
-$21,667
$23,333
-$8,167
$15,167
$21,667
$36,833

$70,000
-$25,000
-$21,667
$23,333
-$8,167
$15,167
$21,667
$36,833

-$75,000

$36,833

$36,833

$70,000
-$25,000
-$21,667
$23,333
-$8,167
$15,167
$21,667
$36,833
$10,000
$5,000
-$1,750
$50,083

#C. Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal, the companys CFO is
considering the following facts:

The new business will require the company to purchase additional fixed assets that will cost $600,000 at t = 0. These costs
will be depreciated on a straight-line basis over three years. (Annual depreciation will be $200,000 per year at t = 1, 2, and 3.)
At the end of three years, the company will get out of the business and will sell the fixed assets at a salvage value of
$100,000.
The project will require a $50,000 increase in net operating working capital at t = 0, which will be recovered at t = 3.
The companys marginal tax rate is 35%.
The new business is expected to generate $2 million in sales each year (at t = 1, 2, and 3). The operating costs excluding
depreciation are expected to be $1.4 million per year.
The projects cost of capital is 12%.
What is the projects net present value (NPV)? $536,697
1
2
3
0
Equipment purchase
-$ 600,000
NOWC
-50,000
Sales increase
$2,000,000
Operating costs
1,400,000
Depreciation
200,000
Oper. inc. before taxes
$ 400,000
Taxes (35%)
140,000
Oper. inc. after taxes
$ 260,000
+Depreciation
200,000
Operating cash flow
$ 460,000
Recovery of NOWC
Equipment sale
Taxes on sale
___________
__________
Net CFs
-$ 650,000
$ 460,000
NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 + $575,000/(1.12)3
$409,273.64 = $536,697.

ACCY122_Sp10_Notes_CapBud_KEY

$2,000,000
1,400,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000

$2,000,000
1,400,000
200,000
$ 400,000
140,000
$ 260,000
200,000
$ 460,000
50,000
+100,000
__________
-35,000
$ 460,000
$ 575,000
= -$650,000 + $410,714.29 + $366,709.18 +