Demonstration Lecture Questions

Topic 4: Capital Budgeting

Question 1

The Salte Corporation is an Australian based company with a large proportion of

foreign shareholders. Its core business is the production of machinery used in the
heavy-industry sector. It has recently completed a $400,000 two-year marketing study
on whether to introduce a new machine to the market. Based on the results, Salte has
estimated that 10,000 of its new machines can be sold annually over the next six years
at a price of $9,615 each. Variable costs per machine are $7,400 and fixed costs total
$12 million a year. Working capital specifically for this project is estimated to be $2
million and will be returned at the end of the projects life.

The cost of the machine includes $40 million to build production facilities and $2.4
million in land. The $40 million investment will be depreciated to zero over the life of
the project. At the end of the project, the facilities including the land will be sold for
an estimated $8.4 million. The market value of the land (which is not tax deductible)
is not expected to change.

Finally, start up costs would also entail fully tax deductible expenses of $1.4 million.
These will be deductible at the end of the first year of production. The tax rate
applicable to Salte is 30%. The after tax discount rate is 10%.

Calculate the NPV of the project and advise Salte on whether it should proceed with
the project.

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Solution Question 1

P/L t=0 t=1 t= 2, 3 4,5 t=6

$000's $000's $000's $000's
Start up costs -1,400
Revenue +96,150 +96,150 +96,150
Variable cost -74,000 -74,000 -74,000
Fixed cost -12,000 -12,000 -12,000
Depreciation expense -6,667 -6,667 -6,667
Gain on sale of facility +6,000
Taxable income 0 +2,083 +3,483 +9,483
Tax paid (30%) 0 625 1,045 2845

Cash Flows t=0 t=1 t= 2, 3 4,5 t=6

$000's $000's $000's $000's
Tax paid (30%) 0 -625 -1,045 -2845
Initial outlay -40,000
Land -2,400
Start up costs -1,400
Revenue +96,150 +96,150 +96,150
Variable cost -74,000 -74,000 -74,000
Fixed cost -12,000 -12,000 -12,000
Working capital -2,000 +2,000
Sale of facility and land +8,400
Net cash flows -45,800 9,525 9,105 17,705

$40 million
Depreciation of project = 6
= $6,666,667 p.a.

Gain on sale

Book value of facilities $0

Book value of land $2,400,000
Total salvage amount $8,400,000
Gain on sale $6,000,000

NPVA = -45,800,000 + 9,525,000(1.1) -1 + 9,105,000. 1 – (1.1) -4 (1.1) -1 +

.1
17,705,000(1.1) -6

= - $909,057 As the NPV is negative, the project should NOT proceed.

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Question 2

A company has the opportunity of buying a new high-tech metal cutter which will
save the company $14,000 each year in labour costs. This metal cutter will cost
$70,000 and will have a useful life of 7 years. It is expected to have a salvage value
of $16,000 and will be depreciated using a straight-line method of depreciation.

If the company goes ahead with the new metal cutter, it can sell its old cutter for
only $5,000 even though the machine has a book value for tax purposes of $8,000.

The new machine will require a working capital injection of $4,500 for the
acquisition of additional scrap metal. The working capital would be recovered at
the end of the 7 year period. The company’s required rate of return is 10% and
the tax rate is 30%.

Required: Should the company acquire the new metal cutter?

Solution Question 2
NEW MACHINE OLD MACHINE
Book value yr 7 0 Book value yr 0 8 000
Salvage value yr 7 16 000 Salvage value yr 0 5 000
Gain on sale 16 000 Loss on sale 3 000

Taxable Income t=0 t= 1- 6 t=7

Net annual cash savings 14 000 14 000

minus Depreciation 10 000 10 000
plus Gain on sale 16 000
minus Loss on sale 3 000
Taxable income -3 000 4 000 20 000

Tax (30%) -900 1 200 6 000

Cash Flows
Tax +900 -1 200 -6 000
Net annual cash savings +14 000 +14 000
Salvage value +5 000 +16 000
Working capital -4 500 +4 500
Outlay -70 000

Net Cash Flow -68 600 +12 800 +28 500

1 − (1.1) −6  28500
NPV = −68600 +12800  +
 0.1  (1.1) 7

= $1 772.34 Accept the project as NPV is positive

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Question 3
You have been observing the surge in health awareness in Australia for some time
and realise that the time is ripe for you to start and run an aerobic exercise centre.
Your family owns a warehouse, which will meet your needs and until recently it
has been renting at $48,000 per year. You estimate that you will need to spend
$100,000 in total. This $100,000 will be made up of an initial cost $50,000 to
renovate the place, $45,000 for new equipment and $5,000 to install the
equipment. You have done a market survey, at a cost of $3,000, which leads you to
believe that you will get 500 members each paying $1000 per year. You have also
found 5 instructors you can hire at $30,000 each. For tax reasons you will expense
the renovation costs immediately and depreciate the equipment (including the
installation cost) over ten years using the straight-line method. However you will
expect the equipment to be full functional for 15 years, which is the life of the
operation. Due to the nature of fitness equipment it will be unlikely to have a
salvage value at the end of 10 years. Assume the initial investment is made today
and all cash flows are received or paid at the end of each year. Your discount rate
is 15% and your tax rate is 40%.
Should you invest in the project?

Solution Question 3

Gain/loss on sale:
Book value yr 15 0
Salvage value yr 15 0
Gain on sale 0

Taxable Income t=0 t=1-10 t= 11 - 15

Revenue 500 000 500 000

minus Instructors costs 150 000 150 000
minus Depreciation 5 000
minus Rent revenue 48 000 48 000
foregone
minus Renovation costs 50 000
minus Gain/loss on sale 0
= Taxable income - 50 000 297 000 302 000

Tax (40%) -20, 000 118, 800 120, 800

Cash Flows t=0 t=1-10 t =11 - 15

Tax +20 000 -118 800 -120 800
Revenue +500 000 +500 000
Instructors costs -150 000 -150 000
Rent revenue foregone -48 000 -48 000
Renovation costs -50 000
Equipment -50 000
Salvage value 0

Net Cash Flow -80 000 +183 200 +181 200

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 1 − (1.15 ) −10  1 − (1.15 ) −5 
NPV = −80000 + 183200   + 181200   (1.15)-10
 0 . 15   0 . 15 

= $989,581

Invest in the project as it has a positive NPV.

Question 4

Greenberg Trading is considering two mutually exclusive projects, one with a four-
year life and one with a nine-year life. The net cash flows from the two projects are as
follows:

Year Project A Project B

0 -$160,000 -$160,000
1 65,000 35,000
2 65,000 35,000
3 65,000 35,000
4 85,000 40,000
5 40,000
6 40,000
7 45,000
8 45,000
9 45,000

Assuming a 10% required rate of return on both projects, calculate each project’s
EAA. Which project should be selected?

Solution Question 4

(a) Project A's EAA:-

Step 1: Calculate the project's NPV:

NPVA = -160 000 + 65 000. 1 – (1.1) -3 + 85 000.(1.1) -4

.1

= $59,701.52

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Step 2: Calculate the EAA:
EAAA = NPV / 1 – (1.1) -4
.1

= $59,701.52 / 3.1699
= $18,833.88

Project B's EAA:-

Step 1: Calculate the project's NPV:
NPVB = -160 000 + 35, 000. 1 – (1.1) -3 + 40 000. 1 – (1.1) -3 (1.1) -3
.1 .1

+ 45 000. 1 – (1.1) -3.(1.1) -6

.1 .
= $64,945.51

Step 2: Calculate the EAA:

EAAB = NPV / 1 – (1.1) -9
.1

= $64,945.51 / 5.759
= $11,277.22

Project A should be selected because it has a higher EAA ($18,834 > $11,277).