Exercises and solutions to capital budgeting problems (RWJ (2013))

Chapter 9

1. Calculating (simple) Payback. What is the payback period for the following set of cash
flows?

Solution:

To calculate the payback period, we need to find the time that the project has recovered its initial
investment. After three years, the project has created:
1 300 + 1 500 + 1 900 = $4 700
In cash flows. This project still needs to create another 5 500 – 4 700 = $800
in cash flows. During the fourth year, the cash flows from the project will be $1,400. So, the payback
period will be 3 years, plus what we still need to make divided by what we will make during the fourth
year. The payback period is:
Payback = 3 + ($800 / $1,400) = 3.57 years

3. Calculating (simple) Payback. Buy Coastal, Inc., imposes a payback cutoff of three years for its
international investment projects. If the company has the following two projects available, should
it accept either of them?

Solution:

Payback for project A is: 2 + (60 000 – 51 000)/21 000 = 2.43 years

Payback for project B is: 3 + (70 000 – 59 000)/230 000 = 3.05 years

Using the payback criterion and a cutoff of 3 years, accept project A and reject project B.
5. Calculating Discounted Payback. An investment project costs $10,000 and has annual cash flows of
$2,900 for six years. What is the discounted payback period if the discount rate is zero percent? What if
the discount rate is 5 percent? If it is 19 percent?

Solution:

Calculating Discounted Payback. An investment project costs $10,000

and has annual cash fl ows of $2,900 for six years. What is the discounted payback
period if the discount rate is zero percent? What if the discount rate is 5 percent? If
it is 19 percent?

PV(Cash flow) PV(Cash flow)

time Cash flow @ 5% Cumulative CF @ 19% Cumulative CF
0 -10,000 -10,000.0 -10,000.0 -10,000.0 -10,000.0
1 2,900 2,761.9 -7,238.1 2,320.9 -7,679.1

Please refer to the table above (you can open this in Excel).

For discounted payback, one has to discount all project cash flows to present and then find a cumulative
sum of these discounted cash flows.

If r=5%, then the project discounted payback is 3 + (2 102.6/2 385.5) = 3.88 years.

If r=19%, then the cumulative sum of discounted cash inflows will be less than an investment. Therefore
there is no discounted payback – e.g. the project doesn’t pay off.

If r=0%, then we have simple payback. In this particular case, where the cash inflows are constant, we
can find the simple payback as 10 000/2 900 = 3.45 years

7. Calculating IRR. A firm evaluates all of its projects by applying the IRR rule. If the required return is 14
percent, should the firm accept the following project?

Solution:
 Microsoft Excel
Worksheet
Or directly in Excel:
The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines
the IRR for this project is:

0 = –$28 000 + $12 000/(1+IRR)1 + $15 000/(1+IRR)2 + $11 000/(1+IRR)3

12. NPV versus IRR. Garage, Inc., has identified the following two mutually exclusive projects:

a. What is the IRR for each of these projects? Using the IRR decision rule, which project should the
company accept? Is this decision necessarily correct?

b. If the required return is 11 percent, what is the NPV for each of these projects? Which project will the
company choose if it applies the NPV decision rule?

c. Over what range of discount rates would the company choose project A? Project B? At what discount
rate would the company be indifferent between these two projects? Explain.

Solution:

Calculating Discounted Payback. An investment project costs $10,000

and has annual cash fl ows of $2,900 for six years. What is the discounted payback
period if the discount rate is zero percent? What if the discount rate is 5 percent? If
it is 19 percent?

PV(Cashflow) PV(Cashflow)
time Cashflow @ 5% Cumulative CF @ 19% Cumulative CF
0 -10,000 -10,000.0 -10,000.0 -10,000.0 -10,000.0
1 2,900 2,761.9 -7,238.1 2,320.9 -7,679.1
2 2,900 2,630.4 -4,607.7 1,857.5 -5,821.6
3 2,900 2,505.1 -2,102.6 1,486.6 -4,335.0
4 2,900 2,385.8 283.3 1,189.7 -3,145.3
5 2,900 2,272.2 2,555.5 952.2 -2,193.1
6 2,900 2,164.0 4,719.5 762.0 -1,431.0
19. MIRR. Slow Ride Corp. is evaluating a project with the following cash flows:

Solution:

Note that IRR fails here, because we have non-conventional cash flows. We’ll calculate MIRR using the
most general method.

General MIRR formula

௡
‫ܨ ܱܥ‬௧ σ ௡௧ୀ଴ ‫ܨܫܥ‬௧ ൈ ͳ ൅ ݇ ௡ି௧
෍ ൌ
ͳ൅ ‫ ݎ‬௧ ͳ ൅ ‫ ܴܴܫ ܯ‬௡
௧ୀ଴

 Where COFt – cash outflow at period t,

 CIFt – cash inflow at period t,
 k – reinvestment rate (for positive cash flows)
 r - financing rate (for discounting negative cash flows;
 n – project lifetime (years)

32

9 400
Left hand side: PV of cash outflows ¿ 29 900+ =35 737
( 1+ 10 % )5
Right hand side: FV of cash inflows
4 3 2 1
¿ 11200 × ( 1+10 % ) +13 900 × ( 1+10 % ) +15 800 × ( 1+10 % ) + 12900 × ( 1+10 % ) =68 206.8
Now we apply basic time value of money formula to find MIRR.

FV 68 206.8
PV = 5
∨35 737=
( 1+ MIRR ) ( 1+10 % )5

68 206.8
MIRR=
√5

35 737
−1=13.8 %

Microsoft Excel
Worksheet
Solution in Excel:
Chapter 10

1. Relevant Cash Flows. Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South
Park to produce garden tools. The company bought some land six years ago for $5 million in anticipation
of using it as a warehouse and distribution site, but the company has since decided to rent these facilities
from a competitor instead. If the land were sold today, the company would net $5.3 million. The
company wants to build its new manufacturing plant on this land; the plant will cost $12.5 million to
build, and the site requires $770,000 worth of grading before it is suitable for construction. What is the
proper cash flow amount to use as the initial investment in fixed assets when evaluating this project?
Why?

Solution:

Initial investment (t=0) = 5.3m + 12.5m + 0.77m = $18.57m

Explanation: the $5 million acquisition cost of the land six years ago is a sunk cost. The $5.3 million
current after-tax value of the land is an opportunity cost if the land is used rather than sold off. The $12.5
million cash outlay and $770,000 grading expenses are the initial fixed asset investments needed to get
the project going. Therefore, the proper Year 0 cash flow to use in evaluating this project is $5,300,000 +
12,500,000 + 770,000 = $18,570,000

2. Relevant Cash Flows. Winnebagel Corp. currently sells 30,000 motor homes per year at $68,000 each
and 12,000 luxury motor coaches per year at $105,000 each. The company wants to introduce a new
portable camper to fill out its product line; it hopes to sell 25,000 of these campers per year at $14,000
each. An independent consultant has determined that if Winnebagel introduces the new campers, it
should boost the sales of its existing motor homes by 2,400 units per year and reduce the sales of its
motor coaches by 1,100 units per year. What is the amount to use as the annual sales figure when
evaluating this project? Why?

Solution:

We need to find the incremental increase in sales as a result of introducing new project.

Incremental annual sales = 25 000*$14 000 + 2 400*$68 000 – 1 100*105 000 = $397.7m

4. Calculating OCF (e.g. operating cash flow). Consider the following income statement:

Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
EBIT = 682.9 – 437.8 – 110.4 = $134.7
Taxes = 34%*134.7 = $45.8
Net income (or actually NOPAT (net operating profit after taxes) =$88.9
OCF = EBIT*(1 – Tc) + Depreciation = 88.9 + 110.4 = $199.3
Depreciation tax shield is calculated as Tc*Depreciation = 34%*110.4 = $37.54
7. Calculating Salvage Value. Consider an asset that costs $640,000 and is depreciated straight-line to
zero over its eight-year tax life. The asset is to be used in a five-year project; at the end of the project,
the asset can be sold for $175,000. If the relevant tax rate is 35 percent, what is the after-tax cash flow
from the sale of this asset?

Solution:

The annual depreciation of the asset is $640 000/8 = $80 000

The book value after 5 years is therefore: 640 000 – 5*80 000 = $240 000

The after tax cash flow from the sale of that asset can be calculated according to the following formula:

After-tax CF = MV - (MV – BV)*(Tc) =175 000 – (175 000 -240 000)*35% = $197.75

Not that as we sell the asset, capital loss occurs. Therefore we’ll gain a tax refund (positive cash flow
from taxes)

13. Project Evaluation. Dog Up! Franks is looking at a new sausage system with an installed cost of
$480,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of
which the sausage system can be scrapped for $70,000. The sausage system will save the firm $160,000
per year in pre-tax operating costs, and the system requires an initial investment in net working capital
of $29,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this
project?

Solution:

Initial investment (t=0): -480 000 – 29 000 = -509 000

Operating cash flow: EBITDA*(1-Tc) + Tc*Depreciation = 160 000*(1-0.34) + 0.34*(480 000/5) = $138 240

(I used here tax shield approach. Alternative approach as in problem 4 can also be used with the same
result)

Terminal cash flow (t=5): +70 000 – (70 000 – 0)*34% + 29 000 = 75 200

(Cash flow from the sale of asset = MV - (MV – BV)*(Tc) )

The project NPV is positive and we should invest.

138.24 138.24 138.24 138.24 75.2+138.24

NPV =−509+ + + + + =61.7 thousand
(1.1 )1 ( 1.1 )2 ( 1.1 )3 ( 1.1 )4 ( 1.1 )5

Microsoft Excel
Worksheet