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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

Chapter 5
,

CAPITAL BUDGETING

QUESTIONS FOR DISCUSSION


5-1. No. Operating budgets charge the entire cost of acquisitions into the current year. Because benefits of an acquisition may extend well beyond the current year, we may incorrectly believe that an acquisition is not worthwhile if the capital budget is made part of the operating budget. A capital budget is needed because it considers costs and benefits of an acquisition over its entire useful lifetime. 5-2. Yes. Approved items from the capital budget are depreciated over their useful lifetimes. The annual depreciation expense becomes a cost included in the operating budget. 5-3. False. In theory, a capital asset is any resource that will provide benefits to the organization in more than one fiscal year. To simplify bookkeeping, however, most organizations only consider items that are expensive and have a lifetime of more than one year to be capital assets. 5-4. Some reasons that capital assets warrant special attention are that (1) the initial cost is large, (2) the items are generally kept a long time, (3) we can only understand the financial impact if we evaluate the entire lifetime of the assets, and (4) because we often pay for the asset early and receive payments as we use it later, the time value of money (or interest cost) related to the acquisition must be considered. Mistakes can be particularly costly because of the long-term commitment. Further, interest costs may not be obvious and may need to be explicitly considered. 5-5. A dollar today is not worth the same amount as a dollar at some future time. If you have the money today, you can invest it and earn a positive return during the time period you would otherwise be waiting to receive the money. Money has an opportunity cost. 5-6. Compound interest simply refers to the fact that when money is invested going forward in time, at some point the interest earned on the money starts to earn interest itself. Discounting is just the reversal of this process as we go backward in time. 5-7. The quarterly interest rate for 3% annually is .75%. The table does not have a column for a .75% interest rate. You could take the average of the .5% and 1% columns to get an approximation of the correct answer. Alternatively, you could solve the exercise using a calculator or a computer that can solve for any interest rate.

Chapter 5: Capital Budgeting

5-2

5-8. The net present cost method is very helpful for comparing projects that have identical lifetimes. If projects have differing lifetimes, you are not comparing equal benefits unless you equalize the lifetimes. We could use the lowest common denominator of the lifetimes, extending both alternatives until their lifetimes are equal. However, the uncertainties in replacement and operating costs going forward in time may be substantial. The annualized cost method overcomes these problems. In that approach, one first finds the Net Present Cost for each alternative. Then, that cost is translated into a periodic payment for the number of years of that individual projects lifetime. The project with the lower annualized cost is less expensive, on an annual basis, in todays dollars. 5-9. Aside from the complexity of calculations, when cash flows are uneven from year to year, there are two important limitations. IRR assumes that cash inflows during the project are reinvested at the same rate that the project earns. Second, sometimes use of the IRR method will cause you to chose incorrectly from two mutually exclusive projects by picking a smaller project with a higher IRR rather than a larger project with a somewhat smaller IRR. 5-10. The objection to the method is that it ignores everything that happens after the payback period. It also does not consider the time value of money.

EXERCISES
Important Notes Re: A. B. C. D. Rounding Excel Solutions Clearing data from calculator memory Solutions using Time Value of Money Tables

A. It is common to have some rounding errors in time value of money calculations. In the following exercises and problems, answers are rounded either to the penny or to the dollar. Exercise care when rounding off before the final calculation. For example, if dividing 8% by 12 to get a monthly rate, the rate should be carried out to at least 4 decimal places. It will not be unusal for answers to differ slightly when using different solution approaches (calculator, formula, Excel) because of different rounding conventions used. B. When solving using Excel or a similar spreadsheet, your actual TVM spreadsheet formula will refer to cell references, such as D12 or E32, rather than numbers or values. However, since each students solution may place the raw data in different cells, the cell references in the formulas shown in different solutions to the problem will be different. If the students are asked to indicate values rather than cell references in their spreadsheet formulas, it will make grading or comparison across students easier. This can also facilitate testing students ability to use Excel for time value of money problems during a test, without computers. C. A common error is failure to clear the calculator memory between calculations. It is important to press the All Clear button on your calculator when starting a new calculation. D. Starting with Exercise 14 and going through Exercise 18, and for selected problems, solutions are shown using the Time Value of Money tables. The tables appear at the end of Chapter 5 in Appendix 5-A and the use of such tables is discussed in that appendix. Students who have not been assigned Appendix 5A should ignore the part of the solutions referring to those tables.

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

5.11.

(Future Value) $8,000 3% = $240 $240 3 years = $720 $8,000 + $720 = $8,720 $8,000 5% = $400 $400 3 years = $1,200 $8,000 + $1,200 = $9,200

5.12. A. Calculator N = 60 Raw Data: Result: 60 N

i = ??? I/Y = .68%

PV = $20,000 -20000 PV PMT 30000 FV

FV = $30,000

B. Spreadsheet Formula Solution =rate(nper,pmt,pv,fv,type,guess) =rate(60, , -20000, 30000) = .68% 5-13. You will have $1,250 with simple interest ($1,000 * .05 * 5 years plus the original $1,000 investment) and $1,251.79 with compound interest (PV = $1,000, N = 60 months, i= 4.5%/12 months, FV = ?). You are better off with 4.5% compounded than with 5% simple interest. 5-14. (Future Value with Quarterly Compounding) A. Math Formula Solution FV = PV(1+i)N 5 FV = $20,000 (1 + 3%) = $20,000 1.15927 = $23,185.48 Annual Compounding FV = $20,000 (1 + .75%)20 = $20,000 1.16184 = $23,223.68 Quartery Compounding B. Financial Calculator Solution Annual Compounding N=5 i = 3% Raw Data: Result: 5 N 3 I/Y

PV = $20,000 -20000 PV PMT

FV = ? FV = 23,185.48

Chapter 5: Capital Budgeting

5-4

Quarterly Compounding N = 5 4 = 20 i = 3%/4 = 0.75% PV = $20,000 Raw Data: Result: C. Spreadsheet Formula Solution Annual Compounding =FV(rate,nper,pmt,pv,type) =FV(3%,5, ,-20000) =$23,185.48 Quarterly Compounding =FV(rate,nper,pmt,pv,type) =FV(.75%,20, ,-20000) =$23,223.68 20 N .75 I/Y -20000 PV PMT

FV = ?

FV = 23,223.68

Note that the PV must be shown as a negative number to result in a positive value for the FV.

D. Time Value of Money Tables (See Appendix 5-A) Annual Compounding FV= PV (FVF from FV of $1 Table 5-A-1, i, N) FV= PV (FVF from FV of $1 Table 5-A-1, 3%, 5) FV= $20,000 1.1593 FV= $23,186.00 Quarterly Compounding FV= PV (FVF from FV of $1 Table 5-A-1, i, N) FV= PV (FVF from FV of $1 Table 5-A-1, .75%, 20) Table does not have a column for .75%. One could interpolate, taking the average result using .5% and 1% as follows: at .5% FV=$20,000 1.1049 = $22,098 at 1.0% FV=$20,000 1.2202 = $24,404 at .75% FV= [($22,098 + $24,404) ) 2] = $46,502/2 = $23,251 5-15. (Present Value) A. Math Formula Solution PV = FV/(1+i)N 8 PV = $5,000/(1 + 5%) PV= $5,000/1.4775 = $3,384.09 B. Financial Calculator Solution N=8 i = 5% FV = $5,000 PV = ? Raw Data: 8 5 -5000 N I/Y PV PMT FV Result: = 3,384.20 C. Spreadsheet Formula Solution =PV(rate,nper,pmt,fv,type)

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

=PV(5%,8, ,-5000) =$3,384.20 D. Time Value of Money Tables (See Appendix 5-A) PV = FV (PVF from PV of $1 Table 5-A-2, i, N) PV = FV (PVF from PV of $1 Table 5-A-2, 5%, 8) PV = $5,000 .6768 PV = $3,384.00 5-16. (Number of Compounding Periods) A. Math Formula Solution PV = FV/(1+i)N N $7,500 = $9,500/(1 + 3%) = 7.997 or rounding, 8 years B. Financial Calculator Solution i = 3% PV = $7,500 Raw Data: Result: N = 7.997 3 I/Y FV = $9,500 -7500 PV PMT N=? 9500 FV

C. Spreadsheet Formula Solution =NPER(rate,pmt,pv,fv,type) =NPER(3%, ,-7500,9500) =7.997238 Note that either the present value or the future value must be input as a negative number. D. Time Value of Money Tables (See Appendix 5-A) PV = FV (PVF from PV of $1 Table 5-A-2, i, N) $7,500 = $9,500 (PVF from PV of $1 Table 5-A-2, 3%, N) $7,500/$9,500 = (PVF from PV of $1 Table 5-A-2, 3%, N) (PVF from PV of $1 Table 5-A-2, 3%, N) = .7895 Looking at Table 5-A-2, the 3% column, we see that .7895 is closest to the factor for N=8 5-17. (Annuity Payment Annuity in Arrears) A. Math Formula Solution FVA = PMT {[(1+i)N 1]/i} $100,000 = PMT {[(1+.04)8 1]/.04} PMT = $100,000/{[(1+.04)8 1]/.04} PMT = $10,852.78

Chapter 5: Capital Budgeting

5-6

B. Financial Calculator Solution N=8 i = 4% Raw Data: Result: C. Spreadsheet Formula Solution =PMT(rate,nper,pv,fv,type) =PMT(4%,8, ,-100000) = $10,852.78 8 N 4 I/Y

FV = $100,000 PV PMT = -10,852.78

PMT = ? 100000 FV

D. Time Value of Money Tables (See Appendix 5-A) FVA = PMT (FVAF from FVA of $1 Table 5-A-3, i, N) $100,000 = PMT (FVAF from FVA of $1 Table 5-A-3, 4%, 8) $100,000 = PMT 9.2142 PMT = $100,000/9.2142 PMT = $10,852.81 5-18. (Annuity in Arrears - Future Value) A. Math Formula Solution FVA = PMT {[(1+i)N 1]/i} FVA = $10,000 {[(1+.06)7 1]/.06} FVA = $83,938.38 B. Financial Calculator Solution N=7 i = 6% Raw Data: Result: C. Spreadsheet Formula Solution =FV(rate,nper,pmt,pv,type) =FV(6%,7,-10000) =$83,938.38 D. Time Value of Money Tables (See Appendix 5-A) FVA = PMT (FVAF from FVA of $1 Table 5-A-3, i, N) FVA = $10,000 (FVAF from FVA of $1 Table 5-A-3, 6%, 7) FVA = $10,000 8.3938 FVA = $83,938.00 7 N 6 I/Y PMT = $10,000 PV -10000 PMT FV = ? FV = 83,938.38

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

5-19. (TVM) a. Note for quarterly compounding, 6% / 4 quarters per year = 1.5% per quarter and 3 years x 4 quarters per year = 12 periods A. Financial Calculator Solution FV = $50,000 Raw Data: Result: B. Spreadsheet Formula Solution =PV(rate,nper,pmt,fv,type) =PV(1.5%,12, ,-50000) =$41,819.37 b. A. Financial Calculator Solution PV = $35,000 Raw Data: Result: B. Spreadsheet Formula Solution =PV(rate,nper,pmt,fv,type) =PV(3%,12, ,-35000) =$49,901.63 No, she will not have $50,000. She is about $98 short of that amount. c. A. Financial Calculator Solution PV = $37,000 Raw Data: Result: 12 N N=12 I/Y = 2.54 FV=50,000 -37000 PV PMT i=? 50000 FV 12 N N=12 3 I/Y i=3% -35000 PV FV = ? PMT FV = 49,901.63 12 N N=12 1.5 I/Y i=1.5% PV = ? -50000 FV

PV PMT = 41,819.37

Chapter 5: Capital Budgeting

5-8

B. Spreadsheet Formula Solution =rate(nper,pmt,pv,fv,type,guess) (remember to show PV as a negative number; =rate(12, ,-37000,50000) there is no annuity payment, so pmt can be left blank with a comma before and after; type and guess may also be left blank, assuming the 50000 FV comes at the END of the 3rd year. Type would be 1 if the FV came at the start of the 3rd year.) = .0254 Note that this is 2.54% per quarter, or 10.16% per year. d. A. Financial Calculator Solution FV = $50,000 Raw Data: Result: B. Spreadsheet Formula Solution =PV(rate,nper,pmt,FV,type) =PV(8%/12,36, ,50000) =($39,362.73) You must pay $39,362.73 now to get $50,000 in 3 years. e. A. Financial Calculator Solution FV = $50,000 Raw Data: Result: B. Spreadsheet Formula Solution =PMT(rate,nper,pv,fv,type) =PMT(2%,12, ,50000) =($3,727.98) You must pay $3,727.98 each quarter to get $50,000 in 3 years. 12 N N=12 2 I/Y i=2% PV PMT = ? PMT = -3,727.98 50000 FV 36 N N=36 8/12 I/Y i=8%/12 PV = ? 50000 FV

PV PMT = -39,362.73

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

f. A. Financial Calculator Solution PV = $100,000 FV=$1,000,000 Raw Data: Result: N = 395.88 7/12 I/Y -100000 PV

i=7%/12 PMT

N =?

1000000 FV

B. Spreadsheet Formula Solution =nper(rate,pmt,pv,fv,type) =PMT(7%/12, ,-100000,1000000) = 395.88 Morduch has a way to go. She will need to work another 396 months or 33 years!

PROBLEMS
5-20. (TVM) A. Financial Calculator Solution PMT = 430 N = 3 12 = 36 Raw Data: Result: B. Spreadsheet Formula Solution =PV(rate,nper,pmt,fv,type) =PV(.75%,36,-430,0,0) or =PV(.75%,36,-430) =$13,522.13 5-21. (NPC) A. Financial Calculator Solution High Security N = 36 PMT = 3,000 Raw Data: Result: 36 N 1 I/Y 36 N .75 I/Y

i = 9 12 = .75%

PV = ? FV

-430 PV PMT = 13,522.13

i = 1%

PV = ? FV

-3000 PV PMT = 90,322.52

Net Present Cost = 90,322.52 + 40,000 = 130,322.52

Chapter 5: Capital Budgeting

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Tight Security N = 36

PMT = 1,200 36 N 1 I/Y

i = 1%

PV = ? FV

Raw Data: Result:

-1200 PV PMT = 36,129.00

Net Present Cost = 36,129.00 + 85,000 = 121,129.00 Choose Tight Security. It is less expensive. B. Spreadsheet Formula Solution High Security NPC= $40,000 + PV(rate,nper,pmt,fv,type) = $40,000 + PV(1%,36,-3000) = $40,000 + $90,322.52 = $130,322.52 Tight Security NPC= $85,000 + PV(rate,nper,pmt,fv,type) = $85,000 + PV(1%,36,-1200) = $85,000 + $36,129.01 = $121,129.01 Tight Security is less expensive. 5-22 (Annualized Cost). French Corp Annual Costs: PMT = $10,000, N = 10, I = 10% = $61,446 Net Present Cost: $275,000 (purchase cost) + $61,446 = $336,446 Annualized Cost: PV = $336,446, N = 10, I = 10% PMT = $54,755 Japan Rail Car Annual Costs: PMT = $15,000, N = 6, I = 10% = $65,329 Net Present Cost: $195,000 (purchase cost) + $65,329= $260,329 Annualized Cost: PV = $260,329, N = 6, I = 10% PMT = $59,773 Select French Corp. Their cars have a lower annualized cost

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

5-23. (Annualized Cost) A. Financial Calculator Solution Bid 1 PMT = 1,000 Raw Data: Result: 5 N i = 8% 8 I/Y N=5 PV =3,992.71 PV = ? -1000 PMT FV

NPC = 20,000 + 3992.71 = 23,992.71 Bid 2 PMT = 1,500 Raw Data: Result: 4 N i = 8% 8 I/Y N=4 PV =4,968.19 PV = ? -1500 PMT FV

NPC = 14,000 + 496819 = 18,96819 . . Bid 1 PV = 23,993.71 Raw Data: Result: . Bid 2 PV = 18,96819 Raw Data: Result: 4 N N=4 i = 8% 5 N N =5 i = 8% PMT = ? PMT =-6,009 PMT = ? PMT =-5,727 FV FV

8 23993.71 I/Y PV

8 18968.19 I/Y PV

Bid 2 has the lowest annualized cost ($5,727 per year versus $6,009 per year). Select Bid 2. B. Spreadsheet Formula Solution First Contractor Present Value = PV(rate,nper,pmt,fv,type)-20000 = PV(8%,5,1000)-20000 = ($23,992.71) First Contractor Annualized Cost = PMT(rate,nper,pv,fv,type) = PMT(8%,5,23992.71) = $(6,009.13)

Chapter 5: Capital Budgeting

5-12

The first Contractors road will cost $6,009 per year in todays dollars. Second Contractor Present Value = PV(rate,nper,pmt,fv,type)-14000 = PV(8%,4,1500)-14000 = ($18,968.19) Second Contractor Annualized Cost = PMT(rate,nper,pv,fv,type) = PMT(8%,4,18968.19) = ($5,726.01) The second Contractors road will cost $5,726 per year in todays dollars, so it is less expensive. 5-24. (Annualized Cost) Outlay Annual Payment i= N= PV of a PMT of At 5% for = Plus Outlay = Annualized PMT for N I PV Annualized cost Model A Raw Data: Result: Raw Data: Result: Model B Raw Data: Result: 30 N 5 I/Y PV =38,431 -2500 PMT FV 20 N 5 I/Y 20 N 5 I/Y PV =62,311 -142311 PV -5000 PMT FV Model A ($80,000) $5,000 5% 20 years $5,000 20 years $62,311 80,000 $142,311 20 years 5% $142,311 $11,419 Model B ($100,000) $2,500 5% 30 years $2,500 30 years $38,431 100,000 $138,431 30 years 5% $138,431 $9,005

PMT =11,419

FV

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

Raw Data: Result:

30 N

5 I/Y

-138431 PV

PMT =9,005

FV

B. Spreadsheet Formula Solution Model A Present Value = PV(rate,nper,pmt,fv,type)-80000 = PV(5%,20,5000)-80000 = ($142,311.05) Model A Annualized Cost = PMT(rate,nper,pv,fv,type) = PMT(5%,20,142311.05) = $(11,419.41) Model B Present Value = PV(rate,nper,pmt,fv,type)-100000 = PV(5%,30,2500)-100000 = ($138,431,13) Model B Annualized Cost = PMT(rate,nper,pv,fv,type) = PMT(5%,30,138431.13) = ($9,005.14) Model A will cost $11,419 per year in todays dollars, and Model B will cost $9,005, so Model B is less expensive. 5-25. (NET PRESENT VALUE) Cash In 0 140 140 140 340 Cash Out 650 25 25 25 25 Net cash flow 650 115 115 115 315 Year 0 1 2 3 4

Chapter 5: Capital Budgeting

5-14

A. Financial Calculator Solution PMT = 115 Raw Data: Result: FV = 315 Raw Data: Result: N=4 4 N 3 N N =3 12 I/Y i = 12% PV =276.21 PV = ? -115 PMT FV

i = 12% 12 I/Y

PV = ? PMT -315 FV

PV =200.19

NPV = 276.21 + 200.19 + ( 650 ) = $173.60 or FV = 115 Raw Data: Result: FV = 115 Raw Data: Result: FV = 115 Raw Data: Result: FV = 315 Raw Data: Result: N=3 3 N N=4 4 N N=2 2 N N =1 1 N i = 12% 12 I/Y PV = ? PMT -115 FV

PV =102.68

i = 12% 12 I/Y

PV = ? PMT -115 FV

PV =91.68

i = 12% 12 I/Y

PV = ? -115 FV

PV PMT =81.85 i = 12% PV = ? PV =200.19 PMT

12 I/Y

-315 FV

NPV = 102.68 + 9168 + 8185 + 200.19 + ( 650 ) = 173.60 . . Decision: Do NOT pursue the investment. It has a negative net present value.

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

B. Spreadsheet Formula Solution = NPV(rate,value1,value2,)-650 = NPV(12%,115,115,115,315)-650 = ($173.60) 5.26. (NET PRESENT VALUE) A. Financial Calculator Solution Raw Data: Result: Raw Data: Result: Raw Data: -350000 N Result: Raw Data: Result: Net Cash Flow FV = 500,000, FV = 450,000, FV = 350,000, FV = 320,000, 4 N 8 I/Y 3 I/Y PV PMT =277,841 PV PMT =235,210 Period N = 1, N = 2, N = 3, N = 4, FV 320000 FV 2 N 8 I/Y 1 N 8 I/Y PV PMT =462,963 -500000 FV

PV PMT =385,802

-450000 FV

Rate i = 8%, i = 8%, i = 8%, i = 8%,

PV = PV = PV = PV = Subtotal

Less Purchase Price NPV = Yes, the NPV is > than 0. Acquire the equipment. B. Spreadsheet Formula Solution = NPV(rate,value1,value2,)-1200000 = NPV(8%,500000,450000,350000,320000)-1200000 = $161,816.27

$462,963 385,802 277,841 235,210 $1,361,816 (1,200,000) $161,816

Chapter 5: Capital Budgeting

5-16

5-27. (TVM) A. Financial Calculator Solution PMT = 25,000 Raw Data: 10 N Result: B. Spreadsheet Formula Solution =PV(rate,nper,pmt,FV,type) =PV(6%,10,25000) =($184,002.18) No. The pension should have been funded over the years that the clerk worked. The taxpayers of those years received the benefits, and money for the pension should have been put aside during those years, rather than upon retirement or in the future. 5-28. (Retirement Analysis) A. Financial Calculator Solution Raw Data: Result: Raw Data: Result: 34 N 10 I/Y -2000 PMT 34 N 10 I/Y -20000 PV N = 10 6 I/Y i=6 PV = ? FV

25000 PV PMT = -184,002

PMT

FV = 510,953

PV

FV = 490,953

FV = $510,953 + $490,953 Total Available = $1,001,907 PV = $1,001,907 i = 8 12 % N = 30 12 PMT = ??? = $7,352 month

Raw Data: Result:

360 N

.6667 I/Y

-1001907 PV PMT = 7,352

FV

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

B. Spreadsheet Formula Solution = FV(rate,nper,pmt,pv,type) = FV(10%,34,-2000,-20000) = $1,001,906.79 = PMT(rate,nper,pv,fv,type) = PMT(8%/12,360,-1001906.79) = $7,351.64 You can draw $7,352 per month for living expenses during retirement. 5-29. (Buy or Lease)
Period 0 1 2 3 4 5 6 Total Cost of Funds Number of Years Annualized Cost PV Lease ($2,500.00) ($7,129.63) ($6,601.51) ($6,112.51) ($5,659.73) PV Own ($31,000.00) ($2,083.33) ($1,929.01) ($1,786.12) ($1,653.82) ($1,531.31) $4,883.81 ($35,099.78)

($28,003) 8.00% 4 ($8,454.80)

6 ($7,592.62)

The problem could also have been solved by calculating the value of the two annuities rather than the individual cash flows as follows:
Annuity Approach Number of periods for the Annuity Payment Purchase or Make Ready PV Of Annuity PV of net resale proceeds Net Present Cost Annualized cost Lease 4 ($7,700) ($2,500.00) ($25,503.38) ($28,003.38) ($8,455) Own 5 ($2,250) ($31,000.00) ($8,983.60) $4,883.81 ($35,099.78) ($7,593)

Buy the van. It costs less on an annualized-cost basis.

Chapter 5: Capital Budgeting

5-18

5-30. Start Year 1 Year 2 Year 3 Year 4 Year 5 Total

(NPV) 50 200 = $10,000 subsidy/year Subsidy $10,000 10,000 10,000 10,000 10,000 $50,000 Cost ($60,000) (1,000) (1,000) (1,000) (1,000) (1,000) ($65,000) Net ($60,000) 9,000 9,000 9,000 9,000 9,000 ($15,000) N 1 2 3 4 5 Present Value ($60,000) 6% 8,491 6 8,010 6 7,557 6 7,129 6 6,725 NPV ($22,088) i

A subsidy of $22,088 would be needed. A. Financial Calculator Solution Raw Data: Result: Raw Data: Result: Raw Data: Result: 3 N 6 I/Y 2 N 6 I/Y 1 N 6 I/Y PV = 8,491 PV = 8,010 PMT -9000 FV -9000 FV

PMT

PV = 7,557

PMT

-9000 FV

Raw Data: Result: Raw Data: Result:

4 N

6 I/Y

PV = 7,129

PMT

-9000 FV

5 N

6 I/Y

PV = 6,725

PMT

-9000 FV

B. Spreadsheet Formula Solution = NPV(6%,9000,9000,9000,9000,9000)-60000 = ($22,088.73)


The ORegan Ambulance Paramedics will need donations of $22,088.73 to cover the shortfall.

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

5.31.

(IRR) Set PV inflows = PV outflows PV of $800/yr. for 7 years = $5,000 A. Financial Calculator Solution N=7 PMT = 800 Raw Data: Result: 7 N I/Y = 2.92 PV = 5000 -5000 PV i=? 800 PMT FV

B. Spreadsheet Formula Solution = Rate(nper,pmt,pv,fv,type,guess) = Rate(7,800,-5000) = 2.92%


5-32. (IRR) A. Financial Calculator Solution

Raw Data: Result:

36 N

I/Y = 2.12

-125000 PV

5000 PMT

FV

IRR, on monthly basis, must multiply by 12 to find IRR per annum 212 12 = 25.44 % . Annual IRR is more than 18%, so accept the contract. B. Spreadsheet Formula Solution = Rate(nper,pmt,pv,fv,type,guess) = Rate(36,5000,-125000) = 2.12% per month = 25.5% Annual rate exceeds 18%, so accept the contract.

Chapter 5: Capital Budgeting

5-20

5.33. (Capital Asset Schedule)


CAPITAL ASSET SCHEDULE Useful Annual Life Depreciation 10 10 8 5 5 5 40 $15,000 15,000 30,000 3,200 3,200 3,200 16,250 $85,850 Accumulated Depreciation Beg of FY 2012 $30,000 30,000 60,000 6,400 6,400 6,400 32,500 $171,700 Depreciation Expense for 2012 $15,000 15,000 30,000 3,200 3,200 3,200 16,250 $85,850 Accumulated Depreciation E of F 2012 nd Y $45,000 45,000 90,000 9,600 9,600 9,600 48,750 $257,550 Net Book Value End of 2012 $105,000 105,000 150,000 6,400 6,400 6,400 601,250 $980,450

ITEM Garbage Trucks Truck 1 Truck 2 Bulldozer Lawn M ower M ower 1 M ower 2 M ower 3 Activity Center Total

Cost $150,000 150,000 240,000 16,000 16,000 16,000 650,000 $1,238,000

CASE STUDY: MEAD MEALS ON WHEELS CENTERPART II1


Problem 3 is a capital budgeting problem. You were asked to decide whether MMWC should spend $625,000 for some new kitchen equipment. The equipment will allow MMWC to prepare 10,400 meals per day. This is an increase of 800 meals per day. That means that MMWC can feed 400 more people per week with the addition of the equipment. Each person that MMWC feeds generates gross revenues of $32. Offsetting this is the marginal (variable) cost of providing them with food. We know from the directors instructions to use the new food bid that the marginal cost of food is $23.25 per person per week. ($24.50 $1.25). So, each additional person that MMWC feeds results in a marginal cash flow (the excess of marginal revenue over marginal expenses) of $32 $23.25, or $8.75 per person per week. Because the new equipment will let you feed 400 additional people per week, purchasing the equipment generates $3,500 ($8.75 per person times 400 people) worth of cash flow each week. To find out if this is enough to justify the purchase of the equipment, you need to do a net-presentvalue analysis. Buying the equipment gives MMWC $3,500 of cash flow per week for 260 weeks (5 years times 52 weeks per year). This is an annuity. The case tells you that your interest cost is 12% per annum, approximately .23% per week (12% interest per annum divided by 52 weeks in a year). (If you did not use a spreadsheet to solve the problem, you probably did the calculations on a quarterly basis. In that case, the periodic interest is 3% per quarter [12% divided by 4 quarters per year] and the number of periods is 20, i.e., 5 years 4 quarters per year).

Mead Meals on Wheels Center and its solution were written by Robert Purtell, Robert F. Wagner Graduate School of Public Service, New York University. Used with permission.

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Instructors Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 3E

Here is the problem setup: Outflows Purchase price = $625,000 Net Inflows PMT = Cash Flow = $3,500 number of weeks in the period that you have chosen. (e.g., for a quarterly model $3,500 13 weeks = $45,500 per quarter) i Interest rate (nper) = 12% divided by the number of periods in the year (n) (e.g., for a quarterly model 12%/4 quarters per year = 3% per quarter) Present Value of the benefits = Present Value of an Annuity (pmt) Cash Flow per period Net Present Value = Present Value of the benefits minus purchase price Depending on whether you did the analysis on a weekly or quarterly basis, the results are as shown below. In both cases, the net present value of the cash flow from the investment is greater than zero. In other words, the equipment more than pays for itself even after we take the cost of capital into account. So, the organization should buy the equipment. Note that the net present values derived from the weekly and quarterly calculations are different. This is due to the timing and frequencies of cash flows in the two models. Theoretically, if MMWC gets paid weekly, the weekly model is more correct. Capital Budget Analysis PV of Equipment Purchase Periodic Revenue from New Equipment Periodic Interest Rate Present Value of Benefit from Equipment Net Present Value Weekly $625,000 $3,500 .23% $683,727 $58,727 Quarterly $625,000 $45,500 3.00% $676,925 $51,925 Annual $625,000 $182,000 12.00% $656,069 $31,069

Problem 4 asks you to prepare an incremental budget for the coming year. Lets review what has happened: Weekly people fedup to 5,200 from 4,800, an increase of 400 per week Revenue per person-weekunchanged at $32 per person per week Food cost per person-week$23.25, down from $24.00 Quarterly depreciationup by $28,125 to account for the new equipment Quarterly interest paymentsup by $18,750 because of the equipment loan First quarter fixed costsup by $2,000 per week because of actual experience Other quarterly fixed costsunchanged All of the calculations are the same as they are in question 1. Using that methodology and the revised data, we get the following budget:

Chapter 5: Capital Budgeting

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Quarter One Revenue $2,163,200 Fixed Costs $520,000 Interest Expense 18,750 Additional Depreciation 28,125 Variable Food Costs 1,571,700 Total Cost $2,138,575 Profit/(Loss) $24,625

Revised Budget Quarter Quarter Two Three $2,163,200 $2,163,200 $442,000 $455,000 18,750 18,750 28,125 28,125 1,571,700 1,571,700 $2,060,575 $2,073,575 $102,625 $89,625

Quarter Four $2,163,200 $481,000 18,750 28,125 1,571,700 $2,099,575 $63,625

Annual Total $8,652,800 $1,898,000 75,000 112,500 $6,286,800 $8,372,300 $280,500