FUNDAMENTAL OF FINANCIAL MANAGEMENT

TUTORIAL: CAPITAL BUDGETING

Problem 1
You are currently working as an independent consultant for Cong Nghiep Constructions
and LPG (Liquefied Petroleum Gas) company. You have been asked by the president to
evaluate the proposed acquisition of a new earth mover. The movers basic price is
$50,000, and it would cost another $10,000 to modify it for special use. Assume that the
mover falls into the MACRS 3- year class, it would be sold after 3 years for $20,000,
and it would require an increase in net working capital (spare parts inventory) of $2,000.
The earth mover would have no effect on revenues, but it is expected to save the firm
$30,000 per year in before-tax operating costs, mainly labor. The firms tax rate is 40%.
a/ What is the depreciable basis for the earth mover?
b/ Is there a tax effect when selling the earth mover? What is the net cash flow from
selling the earth mover?
c/ If the projects cost of capital is 10%, should the earth mover be purchased? Show
your calculations

Year
1
2
3
4
5
6
7
8

Problem 2

Property Class
3-year
5-year
33.33%
20.00%
44.45%
32.00%
14.81%
19.20%
7.41%
11.52%
11.52%
5.76%

7-year
14.29%
24.49%
17.49%
12.49%
8.93%
8.92%
8.93%
4.46%

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IDG is a venture capital fund, based in Vietnam. Currently, this company has access to
a list of potential venture projects. As the funds financial analyst, given the following
information for project X, should the fund undertake this venture? To answer, first
prepare a pro forma income statement for each year. Next calculate operating cash flow
(OCF). Finish the problem by determining total project cash flows for each year and
then calculating NPV assuming a 28% required return. Tax rate is 34%.
Project X involves a new type of graphite composite in-line skate wheel. Projected sales
volume is 6,000 units per year at $1,000 each. Variable cost will run about $400 per
unit, and the product should have a four year life.
Fixed cost for the project will run $450,000 per year. Further, the project will need to
invest a total of $1,250,000 in manufacturing equipment. This equipment is depreciated
under seven-yearMACRS property for tax purposes. By the end of the 4 th year, the
equipment would be sold on the market for half of its original price. Initial net working
capital needed is $1,150,000. After that, net working capital requirements would be 25%
of sales.
Problem 3
Dangerfield Industrial Systems Company (DISC) is trying to decide between two
different conveyor belt systems.
System A costs $430,000, has a four-year life, and requires $110,000 in pretax annual
operating costs.
System B costs $570,000, has a six-year life, and requires $98,000 in pretax annual
operating costs.
Both systems are to be depreciated straight-line to zero over their lives and will have
zero salvage value.
a. Whichever project is chosen, it will not be replaced when it wears out. If the
tax rate is 34 percent and the discount rate is 11 percent, which project
should the firm choose?
b. Suppose that DISC always needs a conveyor belt system; when one wears
out, it must be replaced. Which project should the firm choose now?

Problem 4

FUNDAMENTAL OF FINANCIAL MANAGEMENT

Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated
MBA. The production line would be set up in unused space in Shrieves main plant. The
machinerys invoice price would be approximately $200,000, another $10,000 in
shipping charges would be required, and it would cost an additional $30,000 to install
the equipment. The machinery has an economic life of 4 years, and Shrieves has
obtained a special tax ruling that places the equipment in the MACRS 3-year class. The
machinery is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for 4 years at an
incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can
be sold for $200 in the first year. The sales price and cost are expected to increase by
3% per year due to inflation. Further, to handle the new line, the firms net working
capital for each year would have to equal to 12% of next years sales revenues. The
firms tax rate is 40%,and its discount rate is 10%.
Part A
a. Define incremental cash flow.
b. Should you subtract interest expense when calculating project cash flow?
c. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
d. Now assume that the plant space could be leased out to another firm at
$25,000per year. Should this be included in the analysis? If so, how?
e. Finally, assume that the new product line is expected to decrease sales of the
firms other lines by $50,000 per year. Should this be considered in the analysis?
Part B
a. Disregard the assumptions in part A. What is Shrieves depreciable basis?
What are the annual depreciation expenses?
b. Calculate the annual sales revenues and costs (other than depreciation)
c. Construct annual incremental operating cash flow statements.
d. Estimate the required net working capital for each year, and the cash flow due to
investments in net working capital.
e. Calculate the after-tax salvage cash flow
f. Calculate the project cash flows for each year. Based on these cash flows, what
is the projects NPV? Should we undertake the project?

Problem 5
Basket Wonders (BW) is considering the purchase of a new basket weaving machine.
This machine will cost $50,000 while shipping and installation costs another $20,000.

FUNDAMENTAL OF FINANCIAL MANAGEMENT

The machine, under IRSs regulations, falls under the three-yearMACRS class. Initial
net working capital requirement is $5,000, and is expected to be fully recovered by the
end of the projects life.
Lisa Miller is the firms newly hired expert who currently works in the Purchasing
Division. The company pays her a fixed salary of $7,500 per month to take care of the
companys purchasing activities. Lisa forecasts that with the purchase of this basket
weaving machine, Basket Wonders revenues will increase by $110,000 for each of the
next four years while operating costs will rise by $70,000 for each of the next four
years. This machine will then be sold (scrapped) for $10,000 at the end of the 4 thyear,
when the project ends. This company is in the 40% tax bracket.
a/ What is the depreciable basis for this new basket weaving machine?
b/ Why net working capital is fully recovered at the end of projects life?
c/ Given a discount rate of 20% , calculate the NPV of this project. What should Lisa say
about this project?
Problem 6
Golden Gate Windsurfing Inc. is considering a project to expand its current operation.
Given the following information and assuming straight-line depreciation to zero:
What is the net present value of this project?
Should Golden Gate Windsurfing Inc. accept the project and why?

Market research study = $15,000

Project life = 5 years
Initial investment on fixed assets = $320,000; the fixed assets will be sold for
$30,000 at the end of year 5.
Initial working capital = $25,000 (the money will be recovered on closure of
the project)
Operating income = (sales costs) = $150,000 per year;
Losses in current sales if proceed the project: $20,000 in year 1 and $16,000
in year 2.
Corporate tax rate = 25%
Discount rate 13.45%

Problem 7
Pegasus Telecommunications Ltd (PTL) is considering rolling out a new cable Internet
service, PTL is a taxable publicly listed corporation operating in Australia. PTLs

FUNDAMENTAL OF FINANCIAL MANAGEMENT

management is in the process of analyzing the project using the NPV method, and as a
junior analyst you have been asked to gather the relevant information. For each of the
following items explain briefly (no more than 1 sentence) why that item is or is not
relevant to the NPV computation:
a. Last month, the marketing department ran a focus group to determine
consumer
b. interest in the new service. An invoice for $2,500 has just arrived from the
consultants involved in running the focus group.
b. PTL headquarters allocate central company costs to departments at a rate of
$5,000 per employee per year.
c. PTLs bank will charge an interest of 12% p.a. compounded monthly on the
loan required to purchase the necessary hardware.
d. Equipment purchased will be depreciated straight line over 5 years.
e. The Project will require the use of warehouse space already owned by PTL.
The company estimates that the warehouse is worth $450,000.
Problem 8
Your office is about to purchase a new machine at a cost of $64,000. You have forecast
the following data relating to the salvage value and maintenance costs over the next five
years.
Year
Salvage value at the end
Annual maintenance
of each year ($)
expense ($)
1
50,000
11,000
2
40,000
13,000
3
30,000
18,000
4
23,000
24,000
5
3,500
28,000
Assume that the firm has a 28% tax rate and a 15% p.a. required return on this project,
and use straight-line depreciation.
Should the office replace a machine every year, or every three years, or every five
years?
Problem 9
Kalorie Cola is considering buying a special-purpose bottling machine for $28,000. It is
expected to have a useful life of 7 years with a zero disposal price. The plant manager
estimates the following savings in cash-operating costs:
YEAR

AMOUNT

FUNDAMENTAL OF FINANCIAL MANAGEMENT

1
2
3
4
5
6
7
Total

$10,000
$8,000
$6,000
$5,000
$4,000
$3,000
$3,000
$39,000

The Plant Manager argues that, since the total cash savings ($39,000) exceed the
outlay ($28,000), Kalorie Cola should definitely purchase the machine.
REQUIRED:
a. Calculate whether the bottling machine should be purchased according to the
following methods: (i) Net Present Value, and (ii) Internal Rate of Return. Kalorie
Colas required rate of return is 16% p.a.
b. Explain to the Plant Manager why his logic for purchasing the machine is
flawed. Why cant we compare the total cash savings with the machine cost?