Capital Budgeting Practice Problems - Building The Pride

1. After the long drought of 1992, the manager of Long Branch Farm is considering
the installation of an irrigation system. The system has an invoice price of
$100,000 and will cost an additional $15,000 to install. It is estimated that it will
increase revenues by $20,000 annually, although operating expenses other than
depreciation will also increase by $5,000. The system will be depreciated
straight-line over its depreciable life (5 years) to a zero salvage value. The
system can actually be sold for an estimated $25,000 at the end of 5 years. If
the tax rate on ordinary income is 40 percent and the firm’s required rate of
return is 16 percent, should the firm purchase the system? Why? Show your
work.
(NPV –$48,266.16; IRR –2.43%)
2. Matrix Printers, Inc. is considering entering the laser printing business. An
entirely new plant will be needed which will cost $1,500,000. Land for the plant
will cost an additional $250,000. Both of these costs will be incurred immediately.
The plant will be depreciated straight line over its 15 year life. (Remember the
rule about depreciating land.) In addition to these costs an investment of
$100,000 will be needed for working capital. The plant will generate sales of
$300,000 per year and have associated expenses of $175,000. The firms
marginal tax rate is 34%. The plant will be sold in 15 years for $700,000. What is
the NPV of making this investment if the required rate of return is 16%. Should
they make the investment? (NPV = -$1,130,630)
3. International Soup Company is considering replacing a canning machine. The
old machine is being depreciated by the straight-line method over a 10-year
recovery period from a depreciable cost basis of $120,000. The old machine has
5 years of remaining usable live, at which time its salvage value is expected to be
zero, and it can be sold now for $40,000. This machine has a current book value
of $60,000.
The purchase price of the new machine is $250,000 and it will have shipping and
installation costs of $12,500. It has a 5-year life and an expected salvage value
of $25,000. Annual savings of electricity, labor and materials from use of the
new machine are estimated at $40,000. The new machine will require an
additional inventory of spare parts of $30,000. The company is in a 40 percent
tax bracket, and its cost of capital is 16 percent. The machine will be depreciated
straight line over its five-year life. What should the firm do? Show your work. (
NPV –91,448.31; IRR 0.18%; Payback 4.98)
4. You have been asked by the president of your company to evaluate the
proposed acquisition of a new special-purpose truck. The truck’s basic price is
$50,000 and it will cost another $10,000 to modify it for special use by your firm.
The truck falls into a five-year depreciation class and will be depreciated to zero
over the five-year period. The truck is actually expected to be sold for $20,000

after three years when the project is ended. Use of the truck will require an
increase in net working capital of $2,000 (spare parts). The truck will have no
effect on revenue, but it is expected to save the firm $22,000 per year in beforetax
operating costs, mainly labor. The firm’s marginal tax rate is 40 percent and
the required rate of return on the project is 13 percent. What should you do?
(NPV -$3143.27; IRR 10.39%)
5. Blue Note Jazz Productions has decided to cash in on the country craze by
starting a subsidiary that will promote concerts by "Country Jazz" artists for the
next three years. The country music boom is expected to subside by this time
and the subsidiary will be folded. Blue Note expects that average ticket prices will
be $35 and that ticket sales for the three years will be 300,000 tickets per year.
Fixed cost each year are expected to be $3,000,000 and variable costs are
expected to be 25% of sales. The subsidiary will need $4,000,000 in new
equipment to start up and requires a $300,000 investment in working capital. The
$4,000,000 in equipment will be depreciated straight-line over five years to a zero
salvage value, but will be sold at the end of three years for an estimated
$1,500,000. The firm's marginal tax rate is 40%. What is the NPV of this new
investment if the firm's required rate of return is 12%? What is the IRR? Should
the project be accepted?
(IRR 37.20%; NPV $2,276,314.23; MIRR 29.04%)
6. Southwest Airlines is considering the purchase of a new baggage-handling
machine that moves bags quicker and with less damage. The cost is $160,000.
The machine will be depreciated using the straight line method over its seven
year life. If the machine is purchased, SWA will save $31,000 per year in
damaged bags costs during the first five years. Because of higher maintenance
costs during the last two years the savings will only be $28,000. the firm is in
a34% tax bracket. Given that the firm’s required rate of return is 13%, compute
the NPV and IRR of the investment. Should they make the investment? (NPV –
36,936.03; IRR 5.08%)

7. Ball Corporation is currently evaluating two mutually exclusive projects which
have the following net cash flows:
A
B
0 -$5,000 -$10,000
1 3,000 3,500
2 3,000 3,500
3 3,000 3,500
4 3,500
5 3,500
6 3,500
Both projects have a cost of capital of 10 percent. Totally new equipment must
be procured in 6 years, but Project A would be replicated if it were chosen.
Which project should Ball select, and why?
8. Sony Corporation is considering the purchase of a new phone system for a sales
office in Boise, Idaho. The Lucent Technologies system costs $54,000, has
annual operating expenses of $4,000 and an expected life of 9 years. The
Toshiba system has a cost of $48,000, annual operating expenses of $4,000 and
an expected life of 7 years. Ignoring depreciation and taxes and assuming a cost
of capital of 9 percent for such an investment, which system should Sony
purchase? You are free to use either replacement chain or EAA/EAC analysis.
( Lucent EAA -13,007.14, NPV-77,980.99; Toshiba EAA -13,537.14, NPV -
68,131.81)
9. A small real estate office needs a new copier. They have their choice between
leasing a new copier for $2,000 per year with all maintenance included or they
can purchase their own copier for $4,200 and would incur $1,200 per year in
operating costs. Paper and cartridge costs for the copier would be identical in
either case. The lease would be for a total of 6 years and the copier, if bought,
would have a useful life of 6 years and no expected salvage value at the end of
that time. Determine if owning the machine would be cheaper on a per-year basis
than leasing the machine. Then firm’s tax rate is 34% and the proper required
rate of return for the project would be 7%. (Annual after-tax cost of lease is
$1,320 per year. NPV for purchase of copier is -$6840.66 giving an EAC of
$1,435.14 per year. Take the one with the lowest annual cost – the lease.)
10. You have become very successful and are considering the purchase of a plane
for your firm. The Piper model has an initial cost of $375,000, annual operating
costs of $24,000 and a salvage value of $150,000. Its estimated holding period
is 7 years. The Cessna model has an initial cost of $325,000, but annual
operating costs of $29,500 and an estimated salvage value of $100,000. Its
estimated holding period is 8 years. Your cost of capital is fifteen percent.
Ignoring depreciation and taxes, which model would be the best choice assuming
they both would perform the required tasks?