Solutions to problems of TUTORIAL 5 (Capital Budgeting)

1. Compute the IRR for investments with the following cash flows in years 0, 1 and 2: (-$60, $155, $100) and ($60, -$155, $100). How do you interpret the results in terms of the IRR criterion? Costs Depreciation Taxes (50%) Net Income 33 30 25 10

40 $11 $11

40 $10 $10

40 $16 $16

40 $15 $15

What is the average accounting return (AAR) for the proposed investment? [Ans: 16.25%.] The average net income is [($11 + $10 + $16 + $15)/4] = $13. The average book value is $80, so the AAR is ($13/$80) = .1625 = 16.25%. 2. What is the internal rate of return for the investment described in Problem 3? [Ans: 12.061 %] Cash flows are $51, $50, $56, and $55, respectively over the four-year period. The initial investment is $160. The IRR is 12.0608%. 3. Calculate the IRR of an investment with these cash flows in years 0, 1 and 2: ($792, $1780, $1000). [Ans: 11.1111% and 13.6364%.] The sign of the cash flows changes twice, so there are two IRRs: 11.1111% and 13.6364%. 4. For the investment identified in Problem 5, determine the acceptability of the investment when the required return is 10%; when the required rate of return is 12%; and when the required return is 14%. [Ans: NPVs = $.26, -$.09, and $.06] Calculate the NPV for the investment at each required return. The NPVs are $.26, -$.09, and $.06, respectively, for the three required rates. The investment is acceptable if the required return is either 10% or 14%, but it is unacceptable if the required rate of return is 12%. 5. You can borrow $8000, to be repaid in installments of $2,200 at the end of each of the next 5 years. Use the IRR to determine whether this loan is preferable to borrowing at the market rate of 11.5%. [Ans: 11.6488%] The IRR is of the loan cash flows represents the lender's return and is 11.6488%. Borrowing at the market rate of 11.5% is preferable. 6. A firm is considering the following mutually exclusive investment projects. Project A requires an initial outlay of $500 and will return $120 per year for the next seven years. Project B requires an initial outlay of $5,000 and will return $1,350 per year for the next five years. The required rate of return is 10%. Use the net present value criterion to determine which investment is preferable. [Ans: The NPV for project A is $84.20 and the NPV for project B is $117.58, so B is preferred alternative. (Note that we ignore the difference in the lives of the two assets] 7. Calculate the internal rate of return for each of the projects described in Problem 8. [Ans: The IRRs are 14.9500% and 10.9162% for projects A and B, respectively. Despite the fact that project A has the higher IRR, the solution to Problem 8 indicates that project B is preferable]

8. Calculate the profitability index for each of the investment projects described in Problem 8. [Ans: 1.1684, 1.0235] For project A, the profitability index (PI) is ($584.21/$500) = 1.1684. For project B, the PI is ($5117.58/$5000) = 1.0235. If these two projects were independent of each other, both would be acceptable according to the PI criterion because each PI is greater than 1. This conclusion is consistent with that implied by the NPV and IRR rules for independent projects. However, the projects are mutually exclusive, so the PI criterion cannot be used to select the preferred alternative.

9. Jack does not believe in saving and is interested only in maximizing current consumption. His income is $49,000 this year and $50,000 next year. He has three investment opportunities, each of which costs $5,000. One will pay $6000, one will pay $7000, and one will pay $8000 the following year. The market interest rate is 25%. What is the net present value of each of the investments? How much can Jack spend today? [Ans: - NPV =$200, $600, and $1,400, Jack can spend $91,000 today] The net present values of the three investments are -$200, $600, and $1,400, respectively. Jack will not accept the first one since it has a negative net present value, but he will accept the other two. Jack can spend his current income of $49,000 less the $10,000 investment, plus the present value of next year's income, which is ($65,000/1.25) = $52,000. Thus Jack can spend $91,000 today. To check this, notice that Jack can borrow $52,000 against the future income of $65,000 (i.e., $50,000 plus $15,000 investment income). He will thus have to repay [$52,000(1.25)] = $65,000, which will leave him with exactly zero for next year's consumption, as planned. Note also that this investment strategy provides Jack more consumption than spending all of this years income ($49,000) plus what Jack could borrow against next year's income ($40,000=$50,000/1.25).
10.For the question given below , use the following cash flows for projects A and B: A: (-$2000, $500, $600, $700, $800) B: (-$2000, $950, $850, $400, $300) a) Calculate the payback period for projects A and B. [Ans: 3.25 yrs and 2.5 yrs] b) If the discount rate is 12%, what is the discounted payback period for project A? For B? [ Ans: A doesnt payback, For B it is 4 yrs] c) If A and B are mutually exclusive and the required rate of return is 5%, which should be accepted? [Ans: NPV(A)=$283.26, (B)= $268.08, So A is preferred even though it has the lower IRR] d) If the discount rate is 12%, and A and B are mutually exclusive, which project should be accepted? [Ans: (-$68.59), $ 1.20, B is preferred]

11. Use the following information to solve given questions: Aunt Sally's Sauces, Inc., is considering expansion into a new line of all-natural, cholesterol-free, sodium-free, fat-free, low-calorie tomato sauces. Sally has paid $50,000 for a marketing study which indicates that the new product line would have sales of $650,000 per year for each of the next six years. Manufacturing plant and equipment would cost $500,000, and will be depreciated according to ACRS as a five-year asset. The fixed assets will have no market value at the end of six years. Annual fixed costs are projected at $80,000 and variable costs are projected at 60% of sales. Net working capital requirements are $75,000 for the six-year life of the project; the outlay for working capital will be recovered at the end of six years. Aunt Sally's tax rate is 34% and the firm requires a 16% return. a) Compute the annual depreciation and the ending book value for the fixed assets. [ Ans: Dep for year 4 = 57,600, BV for year 5 = 28,800]

b) Prepare pro forma income statements for the project for years 1 through 6. [ Ans: NI for year 4 = 80,784, for year 6 = 99,792]

c) Compute operating cash flow for the project for years 1 through 6. [ Ans: OCF for year 3 = 151,440; year 6 = 128,592]

d) Compute total projected cash flows for years 0 through 6 for the project. [Ans: Total inflow for
year 6 is $203,592 ] Initial cash outflow is $575,000 (= $500,000 + 75,000). For year 6, recovery of net working capital results in a cash inflow of $75,000. Fixed assets are fully depreciated at the end of year 6 and have zero market value, so there are no consequences for cash flows from disposal of fixed assets at the end of the project's life. Total inflow for year 6 is $203,592 (= $128,592 + $75,000).

e) Compute the net present value and the internal rate of return for the new product line. [ Ans:
$8,338.58, 16.539%.] PV = $152,800/(1.16) + $173,200/(1.16)2 + $151,440/(1.16)3 + $138,384/(1.16)4+ $138,384/(1.16)5 + $203,592/(1.16)6 = $583,338.58. The NPV is ($583,338.58 - $575,000) = $8,338.58, so the new product line is an acceptable investment. The $50,000 marketing study is a sunk cost and irrelevant. IRR is 16.539%.

[Read the book for the following three approaches to compute operating cash flows] f) Use the tax-shield approach to compute the operating cash flow for years 1 through 6.

g) Use the 'bottom-up' approach to compute the operating cash flow for years 1 through 6.

h) Use the 'top-down' approach to compute the operating cash flow for years 1 through 6.

12.Use the following information to solve given problems: B Inc., is considering the introduction of a new product. Production of the new product requires an investment of $140,000 in equipment that has a five-year life. The equipment has no salvage value at the end of five years and will be depreciated on a straight-line basis. B's required return is 15% and the tax rate is 34%. The firm has made the following forecasts: Base case Unit sales Price per unit Variable costs per unit Fixed costs per year 2,100 $ 52 $ 22 $12,000 Lower bound 1,900 $ 51 $ 25 $ 9,550 Upper bound 2,200 $ 60 $ 22 $11,500

a) Compute the annual OCF for the project, using the base case forecast for each variable. b) Compute the NPV for the project, using the base case forecast for each variable. c) Compute the NPV and the IRR for the project under the best case and worst case scenarios. d) Assume that all variables, except unit sales, take on their base case levels. What is the effect on NPV and IRR if unit sales are at their lower bound? Also, compute NPV and IRR under the assumption that unit sales are at their upper bound.

13.

14. 15.

16.

e) Assume that all variables, except price per unit, take on their base case levels. What is the effect on NPV and IRR if price per unit is at its lower bound? Also, compute NPV and IRR under the assumption that price per unit is at the upper bound. f) Assume the base-case forecasts for the project; compute the accounting breakeven point. g) Assume the base-case forecasts and no taxes for the project; compute the cash break-even point. h) Suppose that sales for the project under consideration by B increase from 2,100 units to 2,200 units per year. Compute the DOL for the project at sales of 2,100 units. Use both the definition of the DOL and its algebraic equivalent. Assume B pays no taxes on this project. i) Suppose that sales for the project under consideration by B decrease from 2,100 units to 1,600 units per year. Compute the DOL for the project using the definition of DOL. Assume B pays no taxes on this project. j) Assume that sales increase from 1,600 units to 2,100 units for the project. Compute DOL for the project at sales of 1,600 units. Use both the definition of DOL and its algebraic equivalent. Assume B pays no taxes on this project. The following data have been computed for a firm: when output is 20,000 units, OCF is $50,000 and operating leverage is 2.5. Suppose output increases to 23,000 units; what is the new level of OCF? [Ans: $68,750.] The percentage change in output is (23,000 - 20,000)/20,000 = .15 = 15%. Substituting this value and the DOL value into the definition of DOL, we can solve for the percentage change in OCF: DOL = Percentage change in OCF/Percentage change in Q 2.5 = Percentage change in OCF/.15 The percentage change in OCF = (2.5 .15) = .375 = 37.5%. OCF increases by 37.5%, so the new level of OCF is (1.375 $50,000) = $68,750. For the data in Problem 15, compute the firm's fixed costs. [Ans: $75,000] The alternative formula for computing DOL is: 1 + FC/OCF. Substituting DOL = 2.5 and OCF = $50,000. Since 2.5 = 1 + FC/$50,000, FC = $75,000. Suppose that an investor is considering buying property to use as a parking lot; it costs $10,000. He expects the value of the property to remain constant for the foreseeable future; no depreciation expense will be taken. He also expects that, for the foreseeable future, 6,000 cars per year will use the parking lot at a daily rate of $3 per car. Variable costs are zero, but an attendant must be paid $16,000 per year. Assume the required return is 25% and there are no taxes. Compute the NPV. Is the project acceptable? [ Ans: NPV = -$2,000, so the project is unacceptable.] Sales are ($3 6,000) = $18,000 and net income is ($18,000 - $16,000) = $2,000. Since depreciation and taxes are zero, OCF is also $2,000. Treating this cash flow as a perpetuity, the PV is ($2,000/.25) = $8,000; the NPV is ($8,000 - $10,000) = -$2,000, so the project is unacceptable. Suppose that, in the previous problem, the investor intends to re-evaluate his forecast at the end of the first year. He believes that usage of the parking lot during the first year will be either 5500 or 6500 cars per year, and that the volume of business during the first year will indicate which of these figures will continue beyond the first year. In addition, he believes that each of these figures is equally likely. Compute the NPV. Is the project acceptable? [Ans: NPV of the investment is $1,120. The investment is acceptable.] If sales volume is 5,500 cars per year, sales will be ($3 5,500) = $16,500; net income and OCF will be ($16,500 - $16,000) = $500. At 6,500 cars per year, net income and OCF are $3,500. If the two are equally likely, the expected value of first year OCF is [(.5 $500) + (.5 $3,500)] = $2,000. If sales volume the first year is 5,500 cars, then OCF will be $500 for all subsequent years; the value of this perpetuity, as of the end of the first year, is ($500/.25) = $2,000. Since the property can be sold for $10,000, the investor would sell the property at the end of the first year. On the other hand, at 6500 cars per year,

OCF will be $3,500 and the value of the business would be ($3,500/.25) = $14,000; under these circumstances, the investor will continue to operate the business. Therefore, at the end of the first year, the investor will have an expected cash flow of $2,000, plus either $10,000 in cash or a business worth $14,000. The expected value at the end of the first year is $2,000 + [(.5 $10,000) + (.5 $14,000)] = $14,000. The PV of this $14,000 is ($14,000/1.25) = $11,200, and the NPV of the investment is ($11,200 - $10,000) = $1,120. The investment is acceptable. The option to abandon at the end of the first year has added value to the project.