Year | Investment A end of year cash flows | Investment B end of year cash flows |
2001 | +$200,000 | +$100,000 |
2002 | +400,000 | +100,000 |
2003 | +400,000 | +100,000 |
2004 | +400,000 | +800,000 |
2005 | +600,000 | +1,000,000 |
Both projects require an investment of $1,000,000 at the end of 2000. The required rate of return
for both projects is 10%.
Complete the following chart:
Technique | Investment A | Investment B |
Payback period | ||
Discounted payback period | ||
Net present value | ||
Internal rate of return | ||
Modified internal rate of return (reinvestment rate =10%) |
Use the following information for the next four problems:
The president of Albatross Airlines has asked you to evaluate the proposed acquisition of a new airplane. The aircraft price is $40,000 and it is classified in the 3-year MACRS class. The purchase of the plane would require an increase in net working capital of $2,000. The airplane would increase the firm's before-tax revenues by $20,000 per year, but would also increase operating costs by $5,000 per year. The airplane is expected to be used for 3 years and then sold for $25,000. The firm's marginal tax rate is 40% and the project's cost of capital is 14%. Use the following MACRS rates for 3-year property: 33%; 45%; 15%; 7%
Solutions to Practice in Applying the Capital
Budgeting Techniques
Technique | Investment A | Investment B |
Payback period | 3 years | 4 years |
Discounted payback period | 4 years | 5 years |
Net present value | $458,680 | $416,017 |
Internal rate of return | 24.21% | 19.95% |
Modified internal rate of return (reinvestment rate =10%) | 18.63% | 17.93% |
(Note: terminal value for A = $2,349,220; terminal value for B
= $2,280,510)
Solutions to multiple choice:
Notes | ||
When selecting among mutually exclusive projects or when there is capital rationing | ||
Implicit in the calculations | ||
Considers all cash flows, the time value of money, and the uncertainty of the cash flows | ||
If the NPVs are equal at the required rate of return, then the cross-over rate is the required rate of return | ||
-$40,000 + (-$2,000) = -$42,000 | ||
($20,000-5,000)(0.6) + (0.4)($18,000) = +$16,200 | ||
+$2,000 (working capital) + $25,000 (sales of plane) - $8,880 (tax on sale) = +$18,120 | ||
NCFs:
year 0 = -$42,000 |