Week 4 Capital Budgeting Problem George and William Phelps are considering a 6 year project that would require a cash outlay of $80,000 for equipment and an additional $20,000 for working capital that would be released at the end of the project. The equipment would be depreciated evenly over the 6 years and have a salvage value of $8,000 at the end of 6 years. The project would generate before tax annual cash inflows of $28,500. The tax rate is 35% and the company?s discount rate is 14%. Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based upon the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the internal rate of return? 8. Would you recommend this project or not? Why?

AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98 AC556 Week 4 Capital Budgeting Practice problem: You have the following data about a proposed project: Cost of new equipment Increase need for Working Capital (to be released at end of project) Length of project Salvage Value of equipment at end of project Annual cash savings if equipment is purchased Tax rate Discount rate required of all investements $80,000 $20,000 6 years $8,000 $28,500 35% 14% Required: 1. What is the annual accounting income? 2. What is the annual after tax cash flow? 3. What is the payback based upon the initial cash outflows? 4. What is the discounted payback based on the initial cash outflows? 5. What is the simple rate of return based upon the initial cash outflows? 6. What is the net present value? 7. What is the net present value 8. What is the internal rate of return 9. Would you recommend this project? Why or why not. Note: The solutions do not use formulas. It is highly recommended that student use formulas when preparing the worksheet for their own Week 4 solution. Solution: 1. Annual depreciation amount: Annual depreciation expense = (cost of equipment - salvage value) / life of equipment = ($80,000 - $8000) / 6 years $12,000.00 2. Annual after tax accounting income: Annual cash savings Less: annual depreciation Before tax income Income taxes (35%) $28,500.00 $12,000.00 $16,500.00 $5,775.00 Annual accounting net income $10,725.00 3. Annual after tax net cash inflows: Annual accounting net income Add back non-cash depreciation $10,725.00 $12,000.00 Annual after tax net cash inflows $22,725.00 4. Payback period Payback period = Cost of initial cash outflows (investment) / annual cash inflows = ($80,000 + $20,000) / $22,725.00 = approximately 4.4 years 4.4 5. Discounted Payback Period Annual Cash Inflows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Balance of initial Discounted investment Payback $100,000 1 80,066 1 62,580 1 47,241 1 33,786 1 21,983 1 14% PV Discounted Factor Cash flow $22,725 $22,725 $22,725 $22,725 $22,725 0.87719298 0.76946753 0.67497152 0.59208028 0.51936866 19,934 17,486 15,339 13,455 11,803 Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 14% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.43308 78,017 0.51937 4,155 0.51937 10,387 d payback, the project will not be paid back by the end of the 5th year. 6. Simple Rate of Return Simple Rate of Return = Annual Accounting Income / Initial Cash Outflows = $10,725 / ($80,000 + $20,000) 10.73% 7. Net Present Value Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Net Present Value $(7,441) 8. Internal Rate of Return Cost of Equipment Increase in Working Capital Annual after tax cash inflows Salvage value Release of Working Capital Year 0 0 1-5 5 5 Cash Flow -$80,000 -$20,000 $22,725 $8,000 $20,000 Net Present Value Extrapolating, the IRR would be approximately 11.20% 9. Should the company accept this project? If the hurdle rate is truly 14%, then this project should not be accepted since the actual return is 11%. 11% PV Discount Factor Cash Flows 1.00000 (80,000) 1.00000 (20,000) 3.69590 83,989 0.59350 4,748 0.59350 11,870 $607 Rate of Return Annual Cash Flow PV Factor Year 0 1 2 3 4 5 Year Investment Working Capital Salvage Value After tax Cash flow Totals PV Factors Present Values NET Present Value Net Present Value IRR 14% $22,725 $22,725 $22,725 $22,725 $22,725 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0 -80000 -20000 1 $22,725.00 -100000 $22,725.00 1 0.877192982 -100000 19934.21053 -7,441 ($7,440.91) 11.2128% Balance of Investment Discounted Amount Payback 100,000 19,934 80,066 17,486 62,580 15,339 47,241 13,455 33,786 11,803 21,983 discounted Cash Flows 2 3 1 1 1 1 1 1 4 5 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 $22,725.00 0.769467528 0.6749715162 0.592080277 17486.14958 15338.727706 13455.0243 20000 8000 22725 50725 0.519369 26344.98