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
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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,

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