CAPITAL BUDGETING EXERCISES

CAPITAL BUDGETING EXERCISES BA 115 Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin Beagle, production manager, is considering purchasing a machine that will make the corn dog ...

CAPITAL BUDGETING EXERCISES BA 115 Corn Doggy, Inc. produces and sells corn dogs. The corn dogs are dipped by hand. Austin Beagle, production manager, is considering purchasing a machine that will make the corn dogs. Austin has shopped for machines and found that the machine he wants will cost $262,000. In addition, Austin estimates that the new machine will increase the company’s annual net cash inflows by $40,300. The machine will have a 12- year useful life and no salvage value. Instructions (a) Calculate the cash payback period. (b) Calculate the machine’s internal rate of return. (c) Calculate the machine’s net present value using a discount rate of 10%. (d) Assuming Corn Doggy, Inc.’s cost of capital is 10%, is the investment acceptable? Why or why not? Solution (d) Yes, the investment is acceptable. Indications are that the investment will earn a greater return than 10%. The internal rate of return is estimated to be 11%, and the net present value is positive. Top Growth Farms, a farming cooperative, is considering purchasing a tractor for $455,500. The machine has a 10-year life and an estimated salvage value of $32,000. Delivery costs and set-up charges will be $12,100 and $400, respectively. Top Growth uses straight-line depreciation. Top Growth estimates that the tractor will be used five times a week with the average charge to the individual farmers of $350. Fuel is $50 for each use of the tractor. The present value of an annuity of 1 for 10 years at 9% is 6.418. Instructions For the new tractor, compute the: (a) cash payback period. (b) net present value. (c) annual rate of return. Solution $468,000 Cash payback: ———— = 6 years $78,000 (b) Present value of cash flow ($78,000 × 6.418) = $500,604 Capital investment 468,000 Net present value $ 32,604 (c) $468,000 + $32,000 Average Investment: ————————— = $250,000 2 $468,000 – $32,000 Annual Depreciation: ————————— = $43,600 10 years Annual Net Income: $78,000 – $43,600 = $34,400 $34,400 Average Annual Rate of Return: ———— = 13.76% $250,000 Tom Bat became a baseball enthusiast at a very early age. All of his baseball experience has provided him valuable knowledge of the sport, and he is thinking about going into the batting cage business. He estimates the construction of a state-of-the-art building and the purchase of necessary equipment will cost $630,000. Both the facility and the equipment will be depreciated over 12 years using the straight-line method and are expected to have zero salvage values. His required rate of return is 10% (present value factor of 6.8137). Estimated annual net income and cash flows are as follows: Revenue $329,000 Less: Utility cost 40,000 Supplies 8,000 Labor 141,000 Depreciation 52,500 Other 38,500 280,000 Net income $ 49,000 Instructions For this investment, calculate: (a) The net present value. (b) The internal rate of return. (c) The cash payback period. Solution Scanning the 12-year line, a factor of 6.2069 represents an IRR of approximately 12%. (c) Cash payback period of the investment: $630,000 ÷ $101,500 = 6.21 years. Yappy Company is considering a capital investment of $320,000 in additional equipment. The new equipment is expected to have a useful life of 8 years with no salvage value. Depreciation is computed by the straight-line method. During the life of the investment, annual net income and cash inflows are expected to be $25,000 and $65,000, respectively. Yappy requires a 10% return on all new investments. Present Value of an Annuity of 1 Period 8% 9% 10% 11% 12% 15% 8 5.747 5.535 5.335 5.146 4.968 4.487 Instructions (a) Compute each of the following: 1. Cash payback period. 2. Net present value. 3. Profitability index. 4 Internal rate of return. 5. Annual rate of return. (b) Indicate whether the investment should be accepted or rejected. Solution