Capital Budgeting Question for Practice:

1) Johnny’s Lunches is considering purchasing a new, energy-efficient grill. The grill will cost $20,000 and
will be depreciated according to the 3-year Straight line method. It will be sold for scrap metal after 3
years for $5,000. The grill will have no effect on revenues but will save Johnny’s $10,000 in energy
expenses. The tax rate is 35 percent.

a. What are the operating cash flows in Years 1–3?

b. If the discount rate is 12 percent, should the grill be purchased?

2) Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can purchase the
washer for $6,000 and sell its old washer for $2,000. The new washer will last for 6 years and save
$1,500 a year in expenses. The opportunity cost of capital is 15 percent, and the firm’s tax rate is 40
percent.

a. If the firm uses straight-line depreciation to an assumed salvage value of zero over a 6-year life, what
are the cash flows of the project in Years 0–6? The new washer will in fact have zero salvage value after
6 years, and the old washer is fully depreciated.

b. What is project NPV?

3) Kinky Copies may buy a high-volume copier. The machine costs $100,000 and will be depreciated
straight-line over 5 years to a salvage value of $20,000. Kinky anticipates that the machine actually can
be sold in 5 years for $30,000. The machine will save $20,000 a year in labor costs but will require an
increase in working capital, mainly paper supplies, of $10,000. The firm’s marginal tax rate is 35 percent
and the discount rate is 8 percent. Should Kinky buy the machine?

4) Mutually Exclusive Investments. Here are the cash flow forecasts for two mutually exclusive
projects:

a. Which project would you choose on NPV and IRR basisif the opportunity cost of capital is 2 percent?

b. Which would you choose if the opportunity cost of capital is 12 percent?

c. Why does your answer change?

5) Ilana Industries, Inc., needs a new lathe. It can buy a new high-speed lathe for $1 million. The
lathe will cost $35,000 to run, will save the firm $125,000 in labor costs, and will be useful for 10
years. Suppose that for tax purposes, the lathe will be depreciated on a straight-line basis over
its 10-year life to a salvage value of $100,000. The actual market value of the lathe at that time
also will be $100,000. The discount rate is 10 percent and the corporate tax rate is 35 percent.
What is the NPV of buying the new lathe?

6) PC shopping network may upgrade its modem pool. It last upgraded two years ago, when it
spent $115mn on equipment with an assumed life of 5 years and an assumed salvage value of
$15mn for tax purpose. The firm uses straight line depreciation. The old equipment can be sold
today for $80mn. A new modern pool can be installed today for $150mn. They will have a 3 year
life and will be depreciated to zero using straight line depreciation. The new equipment will
enable the firm to increase sales by $25mn per year and decrease operating cost by $10mn per
year. At the end of the three years, the new equipment will be worthless. Assume the firm’s tax
rate is 35% and the discount rate for the project of this sort is 10%. What is the NPV of the
replacement project?