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Capital Budgeting

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SK Manufacturing Company uses discounted payback period to evaluate investments in capital assets. The

company expects the following annual cash flows from an investment of $3,500,000:

Required:

2. Is the investment desirable if the required payback period is 4 years or less?

In order to compute the discounted payback period, we need to compute the present value of each year’s

cash flow.

Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash

flow during the year)

= 5 + (**$255,500/$456,300)

= 5 + 0.56

= 5.56 years

= $3,500,000 – $3,244,500

= $255,500

(2) Conclusion:

Because the discounted payback period is longer than 4-year period, the investment is not desirable

Question 2: Net present value method:

Sunlight company needs a machine for its manufacturing process. The cost of the new machine is $80,700.

The expected useful life of the machine is 8 years. At the end of 8-year period, the machine would have no

salvage value. After installation, the machine would increase cash inflows by $30,000 per year. Sunlight is

interested to know the net present value of the machine to accept or reject this investment. The minimum

required rate of return of the company is 16% on all capital investments.

Required:

2. Is it acceptable to purchase the machine?

Solution:

The positive net present value (computed above) indicates that the investment is profitable, therefore the

machine should be purchased.

A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the useful life is 15

years with zero residual value.

Required:

2. Is it an acceptable investment if cost of capital is 16%?

Solution:

Internal rate of return factor = Net annual cash inflow/Investment required

= $223,000/$40,000

= 5.575

Now see internal rate of return factor (5.575) in 15 year line of the present value of an annuity if $1 table.

After finding this factor, see the corresponding interest rate written at the top of the column. It is 16%. Internal

rate of return is, therefore, 16%.

(2) Conclusion:

The investment is acceptable because internal rate of return promised by the machine is equal to the cost of

capital of the company.

Question 3: Preference ranking of investment projects

The Martin Company is considering the four different investment opportunities. The selected information

about each proposal is given below:

The present value of cash inflows given above have been computed using a 10% discount rate. The company

is unable to accept all available projects because the funds available for investment are limited.

Required:

1. Compute the profitability index (present value index) for all the projects.

2. Rank the four investment projects according to preference using:

(a). net present value (NPV).

(b). profitability index (PI).

(c). internal rate of return (IRR).

3. Which one is the best approach for Martin Company to rank five competing projects?

Solution:

(2) Preference ranking of projects:

The best method of ranking projects depends on the availability of good reinvestment opportunities. Under

internal rate of return (IRR) method, we assume that the funds released from a project are reinvested in

another project yielding the internal rate of return equal to the previous project. According to IRR, the project

4 is ranked at number one with 19% IRR. It means any funds released from project 4 must be reinvested in

another project yielding an internal rate of return of at least 19% but It might be difficult to find a project with

such a high IRR.

The profitability index (PI) shows the present value of cash inflow generated by each dollar invested in a

project. It assumes that the funds released from a project are reinvested in another project with a return equal

to the discount rate. In our problem, the discount rate is only 10%. Generally, the profitability index is

considered the most dependable method of ranking competing projects.

The net present value (NPV) method considers the net present value figure but does not take into account

the amount of investment required for the project. Therefore, this method is not appropriate for comparing or

ranking competing projects that require different amounts of investment. For example, project 3 is ranked at

number four because of its low net present value but it is the best option if we see at the present value of net

cash inflow generated by each dollar invested in the project (as shown by the profitability index).

Conclusion: From above discussion, we can conclude that the profitability index is the most appropriate and

dependable method of ranking projects for Martin Company.

Question 4: Net present value analysis – total and incremental cost approach

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The National Transport Company has a number of large trucks. One of the trucks is in poor condition and

needs an immediate renovation at a cost of $100,000. An overhaul of engine will also be needed 6-years

from now at a cost of $10,000. If theses costs are incurred, the truck will be useful for 12 years. After 12-year

period, it will be sold at a salvage value (scrap value) of $30,000. At this time, the salvage value of the truck

is $35,000. The total annual revenues of the truck will be $200,000 and the total cost to operate the truck will

be $150,000 per year.

Alternatively, National Transport Company can purchase a new truck for $180,000. The new truck will require

some repairs at the end of 6-year period at a cost of $5,000. Its salvage value will be $30,000 after its useful

life of 12 years. The total annual revenues of the new truck will be $200,000 and its operating cost will be

$110,000 per year.

Required: Should National Transport Company renovate the old truck or purchase a new truck. Use the

following approaches to net present value (NPV) analysis for your answer:

2. Incremental cost approach.

Solution:

* Value from “present value of an annuity of $1 in arrears table“.

**Value from “present value of $1 table”.

= $346,340 – $172,340

= $174,000

Since the NPV of new truck surpasses the NPV of old truck by $174,000, the company should buy the new

truck rather than renovating the old one.

**Value from “present value of $1 table“.

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