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Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.

ISBN: 0-13-611848-8
2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Chapter 15 Capital-Budgeting Decision


Methods of Financing
15.1
(a) Equity Financing:
Let X denote the number of shares to be sold. The total flotation cost would be

(0.06)($25) X = $1.5 X
To net $10 million,

25 X 1.5 X = $10, 000, 000


23.5 X = $10, 000, 000
X = 425,532 shares
Flotation cost = $638,298
(b) Equity Financing:

$10, 000, 000


$10, 000, 000 = $193, 680
1 0.019
Number of bond = $10,193,680 / $1,000 = 10,194 units
Annual interest = (10,194)($1,000)(0.12) = $1,223,280
Flotation cost =

15.2
(a) Equal repayment of the principal:
n

0
1
2
3
4
5
6

Repayment
Interest
Principal
$45,000
$37,500
$30,000
$22,500
$15,000
$7,500

$83,333
$83,333
$83,333
$83,333
$83,333
$83,333

Loan Balance
$500,000
$416,667
$333,333
$250,000
$166,667
$83,333
$0

Page | 1

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

(b) Equal repayment of the interest:


n

0
1
2
3
4
5
6

Repayment
Interest
Principal
$45,000
$45,000
$45,000
$45,000
$45,000
$45,000

$0
$0
$0
$0
$0
$500,000

Loan Balance
$500,000
$500,000
$500,000
$500,000
$500,000
$500,000
$0

(c) Equal annual installment:

A = $500, 000( A / P,9%, 6) = $111, 460


n

0
1
2
3
4
5
6

Repayment
Interest
Principal
$45,000
$39,019
$32,499
$25,392
$17,646
$9,203

$66,460
$72,441
$78,961
$86,068
$93,814
$102,257

Loan Balance
$500,000
$433,540
$361,099
$282,138
$196,070
$102,257
$0

15.3

(a) Equity Financing

Income Statement
Revenue

$100,000 $100,000 $100,000 $100,000

Expenses
Depreciation

$40,000

$64,000

$38,400

$11,520

Taxable Income

$60,000

$36,000

$61,600

$88,480

Income Taxes

$21,000

$12,600

$21,560

$30,968

Net Income

$39,000

$23,400

$40,040

$57,512

Page | 2

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Cash Flow Statement


Cash from operation
Net Income

$39,000

$23,400

$40,040

$57,512

Depreciation

$40,000

$64,000

$38,400

$11,520

Investment/Salvage

($200,000)

$30,000

Gains Tax

$5,628

Net cash flow

($200,000)

PW(10%) =

$74,467

AE(10%) =

$23,492

$79,000

$87,400

$78,440

$104,660

(b) Debt Financing


Income Statement (Bank A)
Revenue
Expenses
Depreciation
Interest

1
2
3
4
$100,000 $100,000 $100,000 $100,000
$40,000
$20,000

$64,000
$15,000

$38,400
$10,000

$11,520
$5,000

Taxable Income
Income Taxes

$40,000
$14,000

$21,000
$7,350

$51,600
$18,060

$83,480
$29,218

Net Income

$26,000

$13,650

$33,540

$54,262

$26,000
$40,000

$13,650
$64,000

$33,540
$38,400

$16,000

$27,650

$21,940

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Investment/Salvage
Gains Tax
Loan Repayment
Net cash flow

$54,262
$11,520
($200,000)
$30,000
$5,628
$200,000 ($50,000) ($50,000) ($50,000) ($50,000)
$0

PW(10%) =

$88,994

AE(10%) =

$28,075

Income Statement (Bank B)


Revenue
Expenses
Depreciation
Interest

Taxable Income
Income Taxes
Net Income

$26,000

$51,410

1
2
3
4
$100,000 $100,000 $100,000 $100,000
$40,000
$20,000

$64,000
$16,724

$38,400
$13,121

$11,520
$9,157

$40,000
$14,000

$19,276
$6,747

$48,479
$16,968

$79,323
$27,763

$12,529

$31,511

$51,560

$54,262

Page | 3

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Investment/Salvage
Gains Tax
Loan Repayment

$26,000
$40,000

$12,529
$64,000

$31,511
$38,400

$51,560
$11,520
($200,000)
$30,000
$5,628
$200,000 ($32,759) ($36,035) ($39,638) ($91,566)
$33,241

$40,494

$30,273

Net cash flow

$0

PW(10%) =

$91,307

AE(10%) =

$28,805

$7,142

(c) Best course of action: Adopt Bank Bs repayment plan


15.4
(a) The total flotation costs to raise $65 million:
Common stock:
amount of common stock = ($65, 000, 000)(0.45)

= $29, 250, 000


$29, 250, 000
flotation cost =
$29, 250, 000 = $1, 410,377
1 0.046

Preferred stock:
amount of preferred stock = ($65, 000, 000)(0.10)

= $6,500, 000
flotation cost =

$6,500, 000
$6,500, 000 = $572,905
1 0.081

Bond:
amount of bond = ($65, 000, 000)(0.45)
= $29, 250, 000
$29, 250, 000
flotation cost =
$29, 250, 000 = $415,314
1 0.014
Total flotation costs = $2,398,596

(b) Number of shares or (bonds) to be sold to raise $65 million:


Common stock:
X S (1 0.046)($32) = $29, 250, 000
X S = 958,137 shares

Page | 4

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Preferred stock:
X P (1 0.081)($55) = $6,500, 000
X P = 128,598 shares

Bond:
X B (1 0.014)($980) = $29, 250, 000
X B = 30, 271 units

(c) Cash requirement to meet financing costs:


Common stock:
annual cash dividends = ($2 / share)(958,137 shares)
= $1,916, 274
Preferred stock:
annual cash dividends = (0.06)($15 / share)(128,598shares)
= $115, 738
Bond:
borrowing amount = (30, 271)($1, 000)
= $30, 271, 000
annual interest = ($30,271,000)(0.12) = $3,632,520
Total annual cash requirement = $5,664,532

Cost of Capital
15.5 After-tax cost of debt:
(a) (0.12)(1 0.25) = 0.09 or 9%
(b) (0.14)(1 0.34) = 0.0924 or 9.24%
(c) (0.15)(1 0.40) = 0.09 or 9%

Page | 5

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

15.6
To provide a yield to maturity of 13% to the bond investors, the bond offering price
should be
P = $110( P / A,13%,10) + $1, 000( P / F ,13%,10)
= $891.48

Now to raise $10 million, The Sweeny would have to sell


$10, 000, 000
= $10,193, 680
1 0.019
Since the $1,000 bond will be sold at a 10.852% discount, the total number of bonds
to be sold would be
$10,193, 680
= 11, 434.56.
891.48
The annual debt interest payment on after-tax basis would be
11, 434,56($1, 000)(0.11)(1 0.35) = $817,571

15.7 Cost of retaining earnings:


kr =

$1.12
+ 0.12 = 18.22%
$18

15.8
(a) Flotation costs in percentage:
fc = 1

15
= 16.67%
18

(b) Cost of new common stock:


ke =

15.9

$1.10
+ 0.10 = 17.33%
$18(1 0.1667)

ie = 0.22
id = (0.13)(1 0.40) = 0.078
k = (0.078)(0.45) + (0.22)(0.55)
= 0.1561

Page | 6

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

15.10
Given: ke = 0.30
(a)
ie = (70 / 70)(0.30) = 0.3
id = (1 0.40)[(10 / 30)(0.14) + (20 / 30)(0.12)] = 0.076
k = (0.076)(0.30) + (0.3)(0.70) = 0.2328
(b)
ie = r f + rM r f = 0.06 + 1.2(0.12 0.06) = 0.132
(c)

k = (0.076)(0.30) + (0.132)(0.70) = 0.1152


15.11 Given: ie = 18%, id = (0.12)(1 0.36) = 0.0768
k = (0.4)(0.0768) + (0.6)(0.18) = 13.87%
(a) Net equity flow method:
PW (18%) = $35,847 > 0 , accept the project.
0
1
2
Income Statement
$90,000 $90,000
Revenue
Expenses
$10,000 $10,000
O&M
$28,580 $48,980
Depreciation
$9,600 $8,089
Interest

$90,000 $90,000 $90,000


$10,000 $10,000 $10,000
$34,980 $24,980 $8,930
$6,396 $4,501 $2,378

Taxable Income
Income Taxes

$41,820 $22,931 $38,624 $50,519 $68,692


$15,055 $8,255 $13,904 $18,187 $24,729

Net Income

$26,765 $14,676 $24,719 $32,332 $43,963

Cash Flow Statement


Cash from operation
$26,765 $14,676 $24,719 $32,332 $43,963
Net Income
$28,580 $48,980 $34,980 $24,980 $8,930
Depreciation
($200,000)
$50,000
Investment/Salvage
$1,278
Gains Tax
$80,000 ($12,593) ($14,104) ($15,796) ($17,692) ($19,815)
Loan Repayment
($120,000) $42,752 $49,552 $43,903 $39,620 $84,356
Net cash flow
PW(18%) = $35,847

Page | 7

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

(b) Cost of capital method:


PW (13.87%) = $41,300 > 0 , accept the project.
0

Income Statement
Revenue
Expenses
O&M
Depreciation

$90,000 $90,000 $90,000 $90,000 $90,000


$10,000 $10,000 $10,000 $10,000 $10,000
$28,580 $48,980 $34,980 $24,980 $8,930
.

Taxable Income
Income Taxes

$51,420 $31,020 $45,020 $55,020 $71,070


$18,511 $11,167 $16,207 $19,807 $25,585

Net Income

$32,909 $19,853 $28,813 $35,213 $45,485

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Investment/Salvage
Gains Tax

$32,909 $19,853 $28,813 $35,213 $45,485


$28,580 $48,980 $34,980 $24,980 $8,930
($200,000)
$50,000
$1,278

Net cash flow


($200,000) $61,489 $68,833 $63,793 $60,193 $105,693
PW(13.87%) = $41,300

15.12
(a) Net equity flow method:
0

Income Statement
Revenue
Expenses
Depreciation
Interest (15%)

1
2
3
4
5
$45,000 $45,000 $45,000 $45,000 $45,000
$20,000 $32,000 $19,200 $11,520
$9,000 $7,665 $6,130 $4,365

$5,760
$2,335

Taxable Income
Income Taxes (30%)

$16,000 $5,335
$4,800 $1,600

$19,670 $29,115 $36,905


$5,901 $8,735 $11,072

Net Income

$11,200 $3,734

$13,769 $20,381 $25,834

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Investment/Salvage
Gains Tax
Loan Repayment

$11,200 $3,734 $13,769 $20,381 $25,834


$20,000 $32,000 $19,200 $11,520 $5,760
($100,000)
$30,000
($5,544)
$60,000 ($8,899) ($10,234) ($11,769) ($13,534) ($15,564)

Net cash flow

($40,000) $22,301 $25,501 $21,200 $18,366 $40,485

PW(20%) =

$33,689

The project is acceptable.

Page | 8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

(b) Cost of capital method:


ie = 20%, id = (0.15)(1 0.30) = 0.105
k = (0.6)(0.105) + (0.4)(0.2) = 14.3%
0

Income Statement
Revenue
Expenses
Depreciation

1
2
3
4
5
$45,000 $45,000 $45,000 $45,000 $45,000
$20,000 $32,000 $19,200 $11,520

$5,760

Taxable Income
Income Taxes

$25,000 $13,000 $25,800 $33,480 $39,240


$7,500 $3,900 $7,740 $10,044 $11,772

Net Income

$17,500

$9,100 $18,060 $23,436 $27,468

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Investment/Salvage
Gains Tax

$17,500 $9,100 $18,060 $23,436 $27,468


$20,000 $32,000 $19,200 $11,520 $5,760
($100,000)
$30,000
($5,544)

Net cash flow

($100,000) $37,500 $41,100 $37,260 $34,956 $57,684

PW(14.3%) =

$39,268

The project also is acceptable.

15.13
(a) Using ie = 15% :
Machine A
Income Statement
Revenue
Expenses
O&M
Depreciation
Interest(10%)

1
2
3
4
5
6
$20,000 $20,000 $20,000 $20,000 $20,000 $20,000
$8,000
$8,000
$1,200

$8,000
$12,800
$1,044

$8,000
$7,680
$873

$8,000
$4,608
$685

$8,000
$4,608
$478

$8,000
$2,304
$250

Taxable Income
Income Taxes (35%)

$2,800
$980

($1,844)
($646)

$3,447
$1,206

$6,707
$2,347

$6,914
$2,420

$9,446
$3,306

Net Income

$1,820

($1,199)

$2,240

$4,359

$4,494

$6,140

Cash Flow Statement


Cash from operation
Net Income
$1,820 ($1,199) $2,240 $4,359 $4,494 $6,140
Depreciation
$8,000 $12,800 $7,680 $4,608 $4,608 $2,304
Investment/Salvage
($40,000)
$4,000
Gains Tax
($1,400)
Loan Repayment
$12,000 ($1,555) ($1,711) ($1,882) ($2,070) ($2,277) ($2,505)
Net cash flow
($28,000) $8,265
PW(15%) = $2,979

$9,890

$8,038

$6,897

$6,825

$8,539

Page | 9

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Machine B
Income Statement
Revenue
Expenses
O&M
Depreciation
Interest (10%)

1
2
3
4
5
6
$28,000 $28,000 $28,000 $28,000 $28,000 $28,000
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000
$12,000 $19,200 $11,520 $6,912 $6,912 $3,456
$1,800 $1,567 $1,310 $1,028
$717
$376
.

Taxable Income
Income Taxes (35%)

$4,200
$1,470

($2,767)
($968)

$5,170
$1,809

$10,060 $10,371 $14,168


$3,521 $3,630 $4,959

Net Income

$2,730

($1,798)

$3,360

$6,539

$6,741

$9,209

Cash Flow Statement


Cash from operation
Net Income
$2,730 ($1,798) $3,360 $6,539 $6,741 $9,209
Depreciation
$12,000 $19,200 $11,520 $6,912 $6,912 $3,456
Investment/Salvage
($60,000)
$8,000
Gains Tax
($2,800)
Loan Repayment
$18,000 ($2,333) ($2,566) ($2,823) ($3,105) ($3,416) ($3,757)
Net cash flow
($42,000) $12,397 $14,835 $12,058 $10,346 $10,237 $14,108
PW(15%) = $5,030

Machine B should be better.

(b) Using k = 0.7(0.15) + 0.3(0.10)(1 0.35) = 12.45% :


Machine A
Income Statement
Revenue
Expenses
O&M
Depreciation

1
2
3
4
5
6
$20,000 $20,000 $20,000 $20,000 $20,000 $20,000
$8,000
$8,000

$8,000
$12,800

$8,000
$7,680

$8,000
$4,608

$8,000
$4,608

$8,000
$2,304

Taxable Income
Income Taxes (35%)

$4,000
$1,400

($800)
($280)

$4,320
$1,512

$7,392
$2,587

$7,392
$2,587

$9,696
$3,394

Net Income

$2,600

($520)

$2,808

$4,805

$4,805

$6,302

Cash Flow Statement


Cash from operation
Net Income
$2,600
Depreciation
$8,000
Investment/Salvage
($40,000)
Gains Tax

($520)
$12,800

$2,808
$7,680

$4,805
$4,608

$4,805
$4,608

$6,302
$2,304
$4,000
($1,400)

($40,000) $10,600 $12,280 $10,488

$9,413

$9,413

$11,206

Net cash flow

PW(12.45%) = $3,178

Page | 10

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

Machine B
Income Statement
Revenue
Expenses
O&M
Depreciation

1
2
3
4
5
6
$28,000 $28,000 $28,000 $28,000 $28,000 $28,000
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000
$12,000 $19,200 $11,520 $6,912 $6,912 $3,456
.

Taxable Income
Income Taxes (35%)

$6,000
$2,100

Net Income

$3,900

($1,200) $6,480
($420) $2,268
$4,212

$7,207

$7,207

$9,454

Cash Flow Statement


Cash from operation
Net Income
$3,900 ($780) $4,212
Depreciation
$12,000 $19,200 $11,520
Investment/Salvage
($60,000)
Gains Tax

$7,207
$6,912

$7,207
$6,912

$9,454
$3,456
$8,000
($2,800)

Net cash flow

($780)

$11,088 $11,088 $14,544


$3,881 $3,881 $5,090

($60,000) $15,900 $18,420 $15,732 $14,119 $14,119 $18,110

PW(12.45%) = $5,410

Machine B should still be better.

(c) Both methods provide the same decision.

Capital Budgeting
15.14 Based on the investment opportunity curve below, the firms optimal capital
budget would be $177 million, if there is no restriction on the firms debt limit.
However, with a budget limit of $100 million, the firm may select projects 5
and 3 first. Since these two projects alone consume $95 million, the firm may
have two choices about utilizing the remaining $5 million funds. First one is to
find any projects whose rates of return exceed the cost of capital. Project 4
comes close to meeting this requirement. However, the firms borrowing rate is
18%, which is greater than the rate of return from project 4. Therefore, the
projects that should be included in the $100 million budget would be projects 5
and 3. If money has to be raised from outside, the firm should raise only $95
million.

Page | 11

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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Rate of Return
90%
5

80%
3

40%
2

32% 30%
7

22%
15%
rate

Borrowing

(18%)

Lending (12%)

Capital budget ($ Million)


15.15
(a) Present worth analysis: With no budget restriction, select alternatives
1,2,3,4,7,13, and 14. The total NPW from the projects is $2,196.
j
1
2
3
4
5
6
7

PW(8%)
$303
$501
$661
$46
-$66
-$814
$47

j
8
9
10
11
12
13
14

PW(8%)
-$208
-$165
-$272
-$1,017
-$248
$126
$512

(b) With a budget limit of $1,800, select alternatives 1, 2, 3,4,13, and 14. The total
amount of investment required is $1,756.

Page | 12

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
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Short Case Studies


ST 15.1
(a)
Total market value = Present value of its expected future net cash flows +
the value of current assets ($5M)

Total market value =stock price per share* number of share outstanding
= $18(1M) = $18M
Present value of its expected future net cash flows = $13M

(b)

Income before tax = $3.5M


Earnings = $2.1M
Income before tax (1-tax rate) = Earnings
Tax rate = 40%
(c)

The case when the financing source is known, we use interest rate of equity
( ie ) as MARR, MARR = ie
c
ie = c ke , since we have only one source of equity, issuing common new
ce
stocks
Debt to equity ratio = total debt/ total equity = 12000/18000 = 2/3
Games Inc. intends to maintain its current debt to equity ratio when financing
to purchase new equipment. Therefore, they will be financing the cost of new
equipment, $10M, the amount of $4M from debt of long term debt and $6M
from equity of stock.
Therefore, cc = ce = $6M

D1 = D0 (1 + g) =1.9(1+0.225) = $2.3275, P0 = 1.8, fc = 0.11

g with the average dividend from 2004 to 2009


1/4

1.9
g=

1
ke =

1 = 0.174

D1
+ g = 0.3193
P0 (1 fc )

Page | 13

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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MARR= ie =

ce
ke = 31.93%
cc

The case when the financing source is unknown, we use k (WACC) as MARR,
MARR= k

k = id

cd
ce
+ ie
cd + ce
cd + ce

cs
ks (1 t m ) , interest rate of term loan after tax = 10%.
cd
c
ie = c ke = 0.3193% from the first case
ce
id =

Games Inc. intends to maintain its current debt to equity ratio when financing
to purchase new equipment. Therefore, they will be financing the cost of new
equipment, $10M, the amount of $4M from debt of long term debt and $6M
from equity of stock.
Therefore,
cc = ce = $6M, cs = cd = $4M
MARR = k = id

cd
ce
+ ie
= 21.56%
cd + ce
cd + ce

(d)
The current stock price*(shares outstanding) = $18(1M)
PW of increasing profit after installing and operating the new machine =
$6,534K
The number of shares to be sold to net $6,000K
= $6,000K / {(1-fc)*stock price per share} = 374,532 shares
The most likely estimate for Games stock price
= {the current total stock price + increasing profit after installing and
operating the new machine}/ total shares outstanding
= {18M +6,534K }/ (1,000,000+374,532)shares
= $17.85
Finally, the most likely estimate for Games stock price may be $ $17.85.

Page | 14

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
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Note) The income statement and cash flows of most likely case are like below:
Income statement
Inflation
Revenue
Expense
Depreciation
Debt Interest rate

1
$48,400
$38,720
$1,445
$400
$7,835
$3,134
$4,701

(1000US$)
2
$53,240
$31,944
$1,234
$400
$19,662
$7,865
$11,797

(1000US$)
2

10%
10%

Taxable income
Income taxes(40%)
Net income

Cash flow statement


Operating activities

Net income
Depreciation

$4,701
$1,445

$11,797
$1,234

Investment activities

Investment
Salvage
Gains tax
financing activities
Borrowed funds
Principal repayment
Common stock
Cash dividend
Net cash flow(Actual $)
PW=

-$10,000
$5,929
-$557

10%

$4,000
$6,000
$0

-$796
$5,350

-$4,000
-$6,742
-$880
$6,782

$6,534

Depreciation base:
Equipment: $10,000,000
Installation expense: (20 employees)(40 hours per week)(2 weeks)($50 per
hour) = $80,000
Depreciation base :$10,080,000 (in todays dollars)
D1: $10, 80,000 (0.1429) = $1,440,432; D2: $10,800,000(0.2449) =
$2,468,592. With the half-year convention, D2 = $1,234,296
Salvage value calculation:
Market value of the equipment decreases at an annual rate of 30%.
Therefore, the salvage value at the end of year 2 would be $10,000,000(1
0.70)2 = $4,900,000 (in todays dollars). The market value (inflated) two
years from now would be $5,929,000.

(e) Not provided

Page | 15

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

ST 15.2
(a) There are 40 alternatives including the do-nothing alternative.
Alternative
(j)

Projects
Selected

Firstyear
Expenditure

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

0
1
2
4
5
6
7
(1,4)
(1,7)
(2,4)
(2,7)
(1,6)
(2,6)
(2,5)
(2,3)
(1,5)
(1,4,7)
(1,4,6)
(1,4,5)
(1,7,6)
(1,7,5)
(2,4,6)
(2,4,5)
(2,4,7)
(2,7,6)
(2,7,5)
(2,3,4)
(2,3,7)
(2,3,6)
(2,3,5)
(1,4,7,6)
(1,4,7,5)
(2,4,7,6)
(2,4,7,5)
(2,3,4,6)
(2,3,4,5)
(2,3,7,6)
(2,3,7,5)
(2,3,4,6,7)
(2,3,4,5,7)

300,000
100,000
50,000
50,000
50,000
70,000
350,000
370,000
150,000
170,000
500,000
300,000
150,000
100,000
350,000
420,000
550,000
400,000
570,000
420,000
350,000
200,000
220,000
370,000
170,000
150,000
170,000
300,000
150,000
620,000
470,000
420,000
270,000
350,000
200,000
370,000
220,000
420,000
270,000

Secondyear
Expenditure

300,000
100,000
300,000
300,000
10,000
100,000
10,000
400,000
310,000

300,000
600,000
500,000
300,000
110,000
100,000
400,000
10,000
310,000
400,000
700,000
410,000
310,000
310,000
600,000
510,000
500,000
800,000
110,000
410,000
410,000
710,000
600,000
900,000
510,000
810,000
610,000
910,000

Engineering
Hours

4,000
7,000
6,000
3,000
3,000

10,000
4,000
13,000
7,000
4,600
7,600
10,000
9,000
7,000
10,000
10,600
13,000
4,600
7,000
13,600
16,000
13,000
7,600
7,000
15,000
9,000
9,600
12,000
10,600
13,000
13,600
16,000
15,600
18,000
9,600
12,000
15,600
18,000

Page | 16

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
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(b) Only 17 alternatives are feasible as shown in part (a).


(c) Without knowing the exact cash flow sequence for each project over the
project life, it is not feasible to determine the optimal capital budget.

ST 15.3
(a) Select A and C with FW(10%) = $4,894. Since there are $500 left over after
selecting A and C, this left-over is lent out at 10% for 3 periods. Therefore, the
total amount available for lending at the end of period 3 is calculated as
follows:
F = $4,894 + $500( F / P,10%,3)
= $5,559.60
(b) Select B and C. The total amount available for lending at the end of period 3 is
$5,740.
(c) With a budget limit of $3,500, the reasonable MARR should be the lending
rate of 10%. (You select A and C and have $500 available for lending.)

ST 15.4
(a) The debt repayment schedule for the loan from the equipment manufacturer:
n

Loan Repayment
Interest
Principal

Loan Balance
$2,000,000

$200,000

$125,491

$1,874,509

$187,451

$138,040

$1,736,469

$173,647

$151,844

$1,584,625

$158,463

$167,028

$1,417,597

$141,760

$183,731

$1,233,866

$123,387

$202,104

$1,031,762

$103,176

$222,315

$809,447

$80,945

$244,546

$564,901

$56,490

$269,001

$295,901

10

$29,590

$295,901

$0

Page | 17

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
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(b) The flotation costs and the number of common stocks to raise $8,500,000:
$8,500, 000
flotation cost =
$8,500, 000 = $749,184
1 0.081
$8,500, 000
= 205,537 shares
number of shares =
(1 0.081)($45)

(c) The flotation costs and the number of $1,000 bonds to raise $10.5 million:
$10,500, 000
$10,500, 000 = $203,364
1 0.019
$10,500, 000
= 11,893units
number of bonds =
(1 0.019)($900)

flotation cost =

Page | 18

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
For information regarding permission(s), write to: Rights and Permissions Department, Pearson Education, Inc., Upper Saddle River, NJ 07458.

ST 15.5
Income Statement
Revenue
Electricity Bill
Excess power
Expenses
O&M
Misc.
Standby power
Overhead
Overhaul
Depreciation
Unit
Inter Equipment
Interest (9%)

(a) The net cash flow the cogeneration project with bond financing
0

10

11

12

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000
$1,500,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000
$1,500,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000
$1,500,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$1,000,000
$6,400
$1,280,000

$500,000
$100,000
$1,070,370

$950,000
$160,000
$1,070,370

$855,000
$96,000
$1,070,370

$770,000
$57,600
$1,070,370

$693,000
$57,600
$1,070,370

$623,000
$28,800
$1,070,370

$590,500

$0

$0

$0

$0

$0

$1,070,370

$1,070,370

$1,070,370

$1,070,370

$1,070,370

$1,070,370

Taxable Income

$2,143,230

$1,633,230

$292,230

$1,915,630

$1,992,630

$591,430

$2,152,730

$2,743,230

$1,243,230

$2,743,230

$2,743,230

$2,743,230

Net Income

$1,371,667

$1,045,267

$187,027

$1,226,003

$1,275,283

$378,515

$1,377,747

$1,755,667

$795,667

$1,755,667

$1,755,667

$1,755,667

$1,371,667

$1,045,267

$187,027

$1,226,003

$1,275,283

$378,515

$1,377,747

$1,755,667

$795,667

$1,755,667

$1,755,667

$1,755,667

$500,000
$100,000

$950,000
$160,000

$855,000
$96,000

$770,000
$57,600

$693,000
$57,600

$623,000
$28,800

$590,500

$590,501

$590,502

$590,503

$590,504

$295,000

Cash Flow Statement


Cash from operation
Net Income
Depreciation
Unit
Inter Equipment
Investment/Salvage
Unit
Inter Equipment
Gains Tax
Loan Repayment
Net cash flow
PW(27%) =

($10,000,000)
($500,000)

$1,000,000
$490,136
($11,893,000)

$10,500,000
$0

$1,971,667

$2,155,267

$1,138,027

$2,053,603

$2,025,883

$1,030,315

$1,968,247

$2,346,168

$1,386,169

$2,346,170

$2,346,171

($8,352,196)

$5,879,590

Page | 19

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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(b) The maximum annual lease amount that ACC is willing to pay is $1,183,771. (By Excel Goal Seek)

Income Statement
Revenue
Electricity Bill
Excess power
Expenses
O&M
Misc.
Standby power
Overhead
Lease

10

11

12

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000 $6,120,000
$480,000 $480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$6,120,000
$480,000

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000 $500,000
$1,000,000 $1,000,000
$6,400
$6,400
$1,280,000 $1,280,000
$1,183,771 $1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

$500,000
$1,000,000
$6,400
$1,280,000
$1,183,771

Taxable Income
Income Taxes (36%)

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829 $2,629,829
$946,738 $946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

$2,629,829
$946,738

Net Income

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090 $1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

Cash from operation


Net Income

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090 $1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090 $1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

$1,683,090

Net cash flow


PW(27%) =

$0
$5,879,590

Page | 20

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8


2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
This material is protected by Copyright and written permission should be obtained from the publisher prior to any prohibited reproduction,
storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.
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In case of an operating lease, the lesser is responsible for maintaining the equipment in good condition during the lease period,
so we may assume that the lesser would be responsible for bearing the overhaul costs.

Page | 21