Capital Budgeting Exercise

2013 Words Jun 14th, 2010 9 Pages
Corporate Finance
Capital Budgeting Exercises

Problem 1
ABC Industries is considering a proposed project whose estimated NPV is \$12 million. This estimate assume that economic conditions will be “average.” However, the CFO realizes that conditions could be better or worse, so he performed a scenario analysis and obtained these results: Economic Probability of Scenario Outcome NPV Recession 0.05 (\$70 million) Below Average 0.20 (\$25 million) Average 0.50 \$12 million Above Average 0.20 \$20 million Boom 0.05 \$30 million Calculate the project’s expected NPV, standard deviation, and 2 coefficient of variation.

Problem 1
E(NPV) = 0.05 (-\$70) + 0.20 (-\$25) + 0.50 (\$12) + 0.20 (\$20) + 0.05 (\$30) = -\$3.5 + -\$5.0 + \$6.0 + \$4.0 + \$1.5 = \$3.0
Price Modification Increase in NOWC Cash outlay for new machine (\$108000) (\$12500) (\$5500) (\$126000)
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Problem 3-C
C. What are the net operating cash flows during the years 1, 2, and 3?
The operating cash flows follow: Year 1 Year 2 After-tax savings \$28600 \$28600 Depreciation tax savings \$13918 \$18979 Net cash flow \$42518 \$47579 Year 3 \$28,600 \$6326 \$34926

Notes: 1. The after-tax cost savings is: \$44000 (1 – t)= \$44000 (0.65) = \$28600. 2. The depreciation expense in each year is the depreciable basis, \$120500, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is \$39765, \$54225, and \$18075. The depreciation tax savings is calculated as the tax rate (35%) times 13 the depreciation expense in each year.

Problem 3-D
D. What is the terminal year cash flow? Salvage value Tax on SV* Return of NOWC Terminal Value * \$65000 (19798) 5500 \$50702

Tax on SV = (\$65000 – \$8435)(0.35) = \$19798. BV in Year 4 = \$120500 (0.07) = \$8435.
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Problem 3-E
E. Should the machine be purchased?
Year 0 1 2 3 Net Cash Flow (\$126000) \$42518 \$47579 \$85628 NPV= PV @ 12% (\$126000) \$37963 \$37930 \$60948 \$10841

The project has an NPV of \$10841; thus, it should be accepted.
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Problem 3-E
Alternatively, place the cash flows on a time line:
12%

0 | -\$126000

3 | \$34926 \$50702 \$85628 With a financial calculator, input the appropriate cash flows into the cash flow register,