Department of Finance

FIN 2372 Advanced Corporate Finance

Tutorial 03
Capital Budgeting

1. Raphael Restaurant is considering the purchase of a Rs.9,000 baking machine. The

machine has an economic life of five years and will be fully depreciated by the
straight-line method. The machine will produce 1,500 desserts per year, with each
costing Rs.2.30 to make and priced at Rs.4.75. Assume that the discount rate is
14% and the tax rate is 34%. Should Raphael make the purchase?

2. The Best Manufacturing Company is considering a new investment. Financial

projections for the investment are tabulated here. The corporate tax rate is 34%.
Assume all sales revenue is received in cash, all operating costs and income taxes
are paid in cash, and all cash flows occur at the end of the year. All net working
capital is recovered at the end of the project.
Year 0 Year 1 Year 2 Year 3 Year 4
Investment Rs. 24,000
Sales revenue Rs. 12,500 Rs. 13,000 Rs. 13,500 Rs. 10,500
Operating costs 2,700 2,800 2,900 2,100
Depreciation 6,000 6,000 6,000 6,000
Net working 300 350 400 300
capital spending
a) Compute the incremental cash flows of the investment for each year.
b) Suppose the appropriate discount rate is 12%. What is the NPV of the
project?

3. Boomerang, Inc., is considering a new three-year expansion project that requires an

initial fixed asset investment of Rs.1.4 million. The fixed asset will be depreciated
straight-line to zero over its three-year tax life, after which it will be worthless. The
project is estimated to generate Rs.1,120,000 in annual sales, with costs of
Rs.480,000. The tax rate is 35% and the required return is 12%. What is the
project’s NPV?

4. In Question 03 above, suppose the project requires an initial investment in net

working capital of Rs.285,000 and the fixed asset will have a market value of
Rs.225,000 at the end of the project. What is the project’s Year 0 net cash flow?
Year 1? Year 2? Year 3? What is the new NPV?

5. Your firm is contemplating the purchase of a new Rs.670,000 computer-based

order entry system. The system will be depreciated straight-line to zero over its
five-year life. It will be worth Rs.50,000 at the end of that time. You will save
Rs.240,000 before taxes per year in order processing costs, and you will be able to
reduce working capital by Rs.85,000 (this is a one-time reduction). If the tax rate is
35%, what is the IRR for this project?

6. Howell Petroleum is considering a new project that complements its existing

business. The machine required for the project costs Rs. 3.8 million. The marketing
department predicts that sales related to the project will be Rs.2.5 million per year
for the next four years, after which the market will cease to exist. The machine will
be depreciated down to zero over its four-year economic life using the straight-line
method. Cost of goods sold and operating expenses related to the project are
predicted to be 25% of sales. Howell also needs to add net working capital of
Rs.150,000 immediately. The additional net working capital will be recovered in
 full at the end of the project’s life. The corporate tax rate is 35%. The required rate
of return for Howell is 16%. Should Howell proceed with the project?

7. You are evaluating two different machines. The machine I costs Rs.215,000, has a
three-year life, and has pretax operating costs of Rs.35,000 per year. The machine
II costs Rs.270,000, has a five-year life, and has pretax operating costs of Rs.44,000
per year. For both machines, use straight-line depreciation to zero over the project’s
life and assume a salvage value of Rs.20,000. If your tax rate is 35% and your
discount rate is 12%, compute the EAC for both machines. Which do you prefer?
Why?

8. A Company is trying to decide between two different conveyor belt systems.

System A costs Rs.290,000, has a four-year life, and requires Rs.85,000 in pretax
annual operating costs. System B costs Rs.405,000, has a six-year life, and requires
Rs.75,000 in pretax annual operating costs. Both systems are to be depreciated
straight-line to zero over their lives and will have zero salvage value. Whichever
system is chosen, it will not be replaced when it wears out. If the tax rate is 34%
and the discount rate is 11%, which system should the firm choose?

9. Suppose in Question 08 above, the company always needs a conveyor belt system;
when one wears out, it must be replaced. Which system should the firm choose
now?

10. Vandale Industries is considering the purchase of a new machine for the production
of latex. Machine A costs Rs.2,900,000 and will last for six years. Variable costs
are 35% of sales, and fixed costs are Rs.195,000 per year. Machine B costs
Rs.5,700,000 and will last for nine years. Variable costs for this machine are 30%
and fixed costs are Rs.165,000 per year. The sales for each machine will be Rs.12
million per year. The required return is 10% and the tax rate is 35%. Both machines
will be depreciated on a straight-line basis. If the company plans to replace the
machine when it wears out on a perpetual basis, which machine should you choose?

11. Consider the following cash flows on two mutually exclusive projects:
Year Project A Project B
0 -Rs. 50,000 -Rs. 65,000
1 30,000 29,000
2 25,000 38,000
3 20,000 41,000
The cash flows of project A are expressed in real terms, whereas those of project B
are expressed in nominal terms. The appropriate nominal discount rate is 13% and
the inflation rate is 4%. Which project should you choose?

12. Sparkling Water, Inc., expects to sell 2.8 million bottles of drinking water each year
in perpetuity. This year each bottle will sell for Rs.1.25 in real terms and will cost
Rs.0.90 in real terms. Sales income and costs occur at year-end. Revenues will rise
at a real rate of 6% annually, while real costs will rise at a real rate of 5% annually.
The real discount rate is 10%. The corporate tax rate is 34%. What is Sparkling
worth today?

13. Etonic Inc. is considering an investment of Rs.365,000 in an asset with an

economic life of five years. The firm estimates that the nominal annual cash
revenues and expenses at the end of the first year will be Rs.245,000 and
Rs.70,000, respectively. Both revenues and expenses will grow thereafter at the
annual inflation rate of 3%. Etonic will use the straight-line method to depreciate its
 asset to zero over five years. The salvage value of the asset is estimated to be
Rs.45,000 in nominal terms at that time. The one-time net working capital
investment of Rs.10,000 is required immediately and will be recovered at the end of
the project. All corporate cash flows are subject to a 34% tax rate. What is the
project’s total nominal cash flow from assets for each year?

14. An equipment costs Rs.94,000, has a three-year life, and costs Rs.8,600 per year to
operate. The relevant discount rate is 12%. Assume that the straight-line
depreciation method is used and that the equipment is fully depreciated to zero.
Furthermore, assume the equipment has a salvage value of Rs.18,000 at the end of
the three-year life. The relevant tax rate is 34%. All cash flows occur at the end of
the year. What is the equivalent annual cost (EAC) of this equipment?

15. Scott Investors, Inc., is considering the purchase of a Rs.360,000 computer with an
economic life of five years. The computer will be fully depreciated over five years
using the straight-line method. The market value of the computer will be Rs.60,000
in five years. The computer will replace five office employees whose combined
annual salaries are Rs.105,000. The machine will also immediately lower the firm’s
required net working capital by Rs.80,000. This amount of net working capital will
need to be replaced once the machine is sold. The corporate tax rate is 34%. Is it
worthwhile to buy the computer if the appropriate discount rate is 12%?

16. A firm is considering an investment in a new machine with a price of Rs.18 million
to replace its existing machine. The current machine has a book value of Rs.6
million and a market value of Rs.4.5 million. The new machine is expected to have
a four-year life, and the old machine has four years left in which it can be used. If
the firm replaces the old machine with the new machine, it expects to save Rs.6.7
million in operating costs each year over the next four years. Both machines will
have no salvage value in four years. If the firm purchases the new machine, it will
also need an investment of Rs.250,000 in net working capital. The required return
on the investment is 10%, and the tax rate is 39%. What are the NPV and IRR of
the decision to replace the old machine?

17. Sanders Enterprises, Inc., has been considering the purchase of a new
manufacturing facility for Rs.270,000. The facility is to be fully depreciated on a
straight-line basis over seven years. It is expected to have no resale value after the
seven years. Operating revenues from the facility are expected to be Rs.105,000, in
nominal terms, at the end of the first year. The revenues are expected to increase at
the inflation rate of 5%. Production costs at the end of the first year will be
Rs.30,000, in nominal terms, and they are expected to increase at 6% per year. The
real discount rate is 8%. The corporate tax rate is 34%. Sanders has other ongoing
profitable operations. Should the company accept the project?

18. Pilot Plus Pens is deciding when to replace its old machine. The machine’s current
salvage value is Rs.2.2 million. Its current book value is Rs.1.4 million. If not sold,
the old machine will require maintenance costs of Rs.845,000 at the end of the year
for the next five years. Depreciation on the old machine is Rs.280,000 per year. At
the end of five years, it will have a salvage value of Rs.120,000 and a book value of
Rs.0. A replacement machine costs Rs.4.3 million now and requires maintenance
costs of Rs.330,000 at the end of each year during its economic life of five years.
At the end of the five years, the new machine will have a salvage value of
Rs.800,000. It will be fully depreciated by the straight-line method. In five years a
replacement machine will cost Rs.3,200,000. Pilot will need to purchase this
machine regardless of what choice it makes today. The corporate tax rate is 40%
and the appropriate discount rate is 8%. The company is assumed to earn sufficient
 revenues to generate tax shields from depreciation. Should Pilot Plus Pens replace
the old machine now or at the end of five years?

19. Office Automation, Inc., must choose between two copiers, the X or the R. The X
costs Rs.900 and will last for three years. The copier will require a real after-tax
cost of Rs.120 per year after all relevant expenses. The R costs Rs.1,400 and will
last five years. The real after-tax cost for the R will be Rs.95 per year. All cash
flows occur at the end of the year. The inflation rate is expected to be 5% per year,
and the nominal discount rate is 14%. Which copier should the company choose?

20. A company is considering investing in a machine to produce computer keyboards.

The price of the machine will be Rs.975,000, and its economic life is five years.
The machine will be fully depreciated by the straight-line method. The machine
will produce 20,000 keyboards each year. The price of each keyboard will be Rs.40
in the first year and will increase by 5% per year. The production cost per keyboard
will be Rs.15 in the first year and will increase by 6% per year. The project will
have an annual fixed cost of Rs.195,000 and require an immediate investment of
Rs.25,000 in net working capital. The corporate tax rate for the company is 34%. If
the appropriate discount rate is 11%, what is the NPV of the investment?

21. Suppose we are thinking about replacing an old computer with a new one. The old
one cost us Rs.450,000; the new one will cost Rs.580,000. The new machine will
be depreciated straight-line to zero over its five-year life. It will probably be worth
about Rs.130,000 after five years. The old computer is being depreciated at a rate of
Rs.90,000 per year. It will be completely written off in three years. If we don’t
replace it now, we will have to replace it in two years. We can sell it now for
Rs.230,000; in two years it will probably be worth Rs.60,000. The new machine
will save us Rs.85,000 per year in operating costs. The tax rate is 38%, and the
discount rate is 14%.
a. Suppose we recognize that if we don’t replace the computer now, we will be
replacing it in two years. Should we replace now or should we wait? ( Hint:
What we effectively have here is a decision either to “invest” in the old
computer—by not selling it—or to invest in the new one. Notice that the
two investments have unequal lives.)
b. Suppose we consider only whether we should replace the old computer now
without worrying about what’s going to happen in two years. What are the
relevant cash flows? Should we replace it or not? ( Hint: Consider the net
change in the firm’s after-tax cash flows if we do the replacement.)

22. Benson Enterprises is evaluating alternative uses for a three-story manufacturing

and warehousing building that it has purchased for Rs.1,450,000. The company can
continue to rent the building to the present occupants for Rs.61,000 per year. The
present occupants have indicated an interest in staying in the building for at least
another 15 years. Alternatively, the company could modify the existing structure to
use for its own manufacturing and warehousing needs. Benson’s production
engineer feels the building could be adapted to handle one of two new product
lines. The cost and revenue data for the two product alternatives are as follows:

Product A Product B
Initial cash outlay for building modifications Rs. 95,000 Rs.125,000
Initial cash outlay for equipment 195,000 230,000
Annual pretax cash revenues (generated for 15 years) 180,000 215,000
Annual pretax expenditures (generated for 15 years) 70,000 90,000
 The building will be used for only 15 years for either Product A or Product B. After
15 years the building will be too small for efficient production of either product
line. At that time, Benson plans to rent the building to firms similar to the current
occupants. To rent the building again, Benson will need to restore the building to its
present layout. The estimated cash cost of restoring the building if Product A has
been undertaken is Rs.55,000. If Product B has been manufactured, the cash cost
will be Rs.80,000. These cash costs can be deducted for tax purposes in the year the
expenditures occur.
Benson will depreciate the original building shell (purchased for Rs.1,450,000)
over a 30-year life to zero, regardless of which alternative it chooses. The building
modifications and equipment purchases for either product are estimated to have a
15-year life. They will be depreciated by the straight-line method. The firm’s tax
rate is 34%, and its required rate of return on such investments is 12%.
For simplicity, assume all cash flows occur at the end of the year. The initial
outlays for modifications and equipment will occur today (Year 0), and the
restoration outlays will occur at the end of Year 15. Benson has other profitable
ongoing operations that are sufficient to cover any losses. Which use of the
building would you recommend to management?

23. The Biological Insect Control Corporation (BICC) has hired you as a consultant to
evaluate the NPV of its proposed project. They anticipate that the business will
continue into perpetuity. Following the negligible start-up costs, BICC expects the
following nominal cash flows at the end of the year:

Revenues Rs. 265,000

Labour costs 185,000
Other costs 55,000

The company will lease machinery for Rs.90,000 per year. The lease payments start
at the end of Year 1 and are expressed in nominal terms. Revenues will increase by
4% per year in real terms. Labor costs will increase by 3% per year in real terms.
Other costs will increase by 1% per year in real terms. The rate of inflation is
expected to be 6% per year. BICC’s required rate of return is 10% in real terms.
The company has a 34% tax rate. All cash flows occur at year-end. What is the
NPV of BICC’s proposed project today?

24. Sony International has an investment opportunity to produce a new HDTV. The
required investment on January 1 of this year is Rs.165 million. The firm will
depreciate the investment to zero using the straight-line method over four years.
The investment has no resale value after completion of the project. The firm is in
the 34% tax bracket. The price of the product will be Rs.495 per unit, in real terms,
and will not change over the life of the project. Labor costs for Year 1 will be
Rs.15.75 per hour, in real terms, and will increase at 2% per year in real terms.
Energy costs for Year 1 will be Rs.3.80 per physical unit, in real terms, and will
increase at 3% per year in real terms. The inflation rate is 5% per year. Revenues
are received and costs are paid at year-end. Refer to the following table for the
production schedule:

Year 1 Year 2 Year 3 Year 4

Physical production, in units 140,000 150,000 170,000 160,000
Labor input, in hours 1,120,000 1,200,000 1,360,000 1,280,000
Energy input, physical units 210,000 225,000 255,000 240,000

The real discount rate for Sony is 4%. Calculate the NPV of this project.
25. After extensive medical and marketing research, Pill, Inc., believes it can penetrate
the pain reliever market. It is considering two alternative products. The first is a
medication for headache pain. The second is a pill for headache and arthritis pain.
Both products would be introduced at a price of Rs.8.35 per package in real terms.
The headache-only medication is projected to sell 3 million packages a year,
whereas the headache and arthritis remedy would sell 4.5 million packages a year.
Cash costs of production in the first year are expected to be Rs.4.10 per package in
real terms for the headache-only brand. Production costs are expected to be Rs.4.65
in real terms for the headache and arthritis pill. All prices and costs are expected to
rise at the general inflation rate of 3%.
Either product requires further investment. The headache-only pill could be
produced using equipment costing Rs.23 million. That equipment would last three
years and have no resale value. The machinery required to produce the broader
remedy would cost Rs.32 million and last three years. The firm expects that
equipment to have a Rs.1 million resale value (in real terms) at the end of Year 3.
Pill, Inc., uses straight-line depreciation. The firm faces a corporate tax rate of 34%
and believes that the appropriate real discount rate is 7%. Which pain reliever
should the firm produce?