EXERCISES: CAPITAL BUDGETING

Problem 1
Ms. Faye Santos is an accounting major at a Midwestern state university located approximately 60
miles from a major city. Many of the students attending the university are from the metropolitan
areas and visit their homes regularly on the weekends. Faye, an entrepreneur at heart, realizes that
few good commuting alternatives are available for students doing weekend travel. She believes that
a weekend commuting service could be organized and run profitably from several suburban and
downtown shopping mall locations. Faye has gathered the following investment information.

1. Five used vans would cost a total of $75,000 to purchase and would have a three-year useful
life with negligible salvage value. Faye plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total payroll expense of $48,000.
3. Other annual out-of-pocket expenses associated with running the commuter service would
include: Gasoline $16,000; Maintenance- $3,300; Repairs- $4,000; Insurance - $4,200; and
Advertising - $2,500.
4. Faye has visited several financial institutions to discuss funding. The best interest rate she
has been able to negotiate is 15%. Use this rate for cost of capital.
5. Faye expects each van to make 10 round trips weekly and carry an average of six students
each trip. The service is expected to operate 30 weeks each year, and each student will be
charged $12.00 for a round-trip ticket.

Instructions:
a. Determine the (1) net income and (2) net annual cash flows for the commuter service.
b. Compute (1) the cash payback period and (2) the annual rate of return. (Round to two
decimals)
c. Compute the net present value of the commuter service. (round to the nearest dollar)
d. What should Faye conclude from these computations?

NET INCOME

5*10*6*30*12 108K

LESS:

GAS 16

MAINTE 3.3K
 REPAIRS 4K

INSURANCE 4.2K

ADS 2.5K

PAYROLL 48K

DEP 75/3 25K

NET INCOME 5

CASH FLOWS

NET INCOME 5K

ADD: DEP 25K

ANNUAL CASH FLOWS 30K

B.

Cash payback period = Initial investment / Annual cash inflows = $75,000 / $30,000= 2.5 years
Annual rate of return = Average annual income / Average investment
Average investment = (Cost + Salvage value) / 2 = $75,000/2 = $37,0000
Annual rate of return = $5,000 / $30,000 = 16.667%

C.

AMOUNT PERIOD PV FACTOR PRESENT VALUE

OUTFLOW
COST OF 75,000 1 75,000
INVESTMENT
INFLOWS
ANNUAL CASH 30,000 1-3 2.28323 68,496.9
 INFLOW

D. FAYE CAN INVEST IN SUCH BUSINESS HOWEVER, THE CASHBACK PERIOD CANNOT BE
ASCERTAINED FOR THERE ARE MANY VARIABLES TO BE CONSIDERED SUCH AS A VARIANCE IN COST.

PROBLEM 2
Contact Manufacturing, Inc., is considering two alternative investment proposals. The first proposal
calls for a major renovation of the company’s manufacturing facility. The second involves replacing
just a few obsolete pieces of equipment in the facility. The company will choose one project or the
other this year, but it will not do both. The cash flows associated with each project appear below
and the firm discounts project cash flows at 15 percent.

Year Renovate Replace

0 –$9,000,000 –$2,400,000
1 3,000,000 2,000,000
2 3,000,000 800,000
3 3,000,000 200,000
4 3,000,000 200,000
5 3,000,000 200,000
Assignment
1. Calculate the payback period of each project and based on this criteria for which project would
you recommend acceptance?
2. Calculate the net present value (NPV) of each project and based on this criteria for which project
would you recommend acceptance?
3. Calculate the internal rate of return (IRR) of each project and based on this criteria for which
project would you recommend acceptance?
4. Calculate the profitability index (PI) of each project and based on this criteria for which project
would you recommend acceptance?
8. Discuss the important elements to consider when deciding between these two projects.

Renovate
Year 0 1 2 3 4 5 
Cash Flow $(9,000,000) $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000 
Cum Cash Flow $(9,000,000) $(6,000,000) $(3,000,000) $-   $3,000,000 $6,000,000 
PVF at 15% 1.000 0.870 0.756 0.658 0.572 0.497 
PVCF $(9,000,000) $2,608,696 $2,268,431 $1,972,549 $1,715,260 $1,491,530 
Payback Period 3 years
NPV $1,056,465
IRR 19.86%

 Replace
Year 0 1 2 3 4 5 
Cash Flow $(2,400,000) $2,000,000 $800,000 $200,000 $200,000 $200,000 
Cum Cash Flow $(2,400,000) $(400,000) $400,000 $600,000 $800,000 $1,000,000 
PVF at 15% 1.000 0.870 0.756 0.658 0.572 0.497 
PVCF $(2,400,000) $1,739,130 $604,915 $131,503 $114,351 $99,435 
Payback Period 1.50 Years
 =1+(400000/800000)
NPV $289,335
IRR 23.69%