FINA 301 Capital Budgeting Exercises | Performance Evaluation|Exercises

FINA 301 Capital Budgeting Exercises are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs \$1500 initially, and then \$400 per year in maintenance costs. Machine B costs \$2000 initially, has a life of three years, and requires \$300 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine for the firm? The discount rate is 6% and the tax rate is zero.

 Year 0 1 2 3 Machine A’s Cash Flows -1500 -400 -400 Machine B’s Cash Flows -2000 -300 -300 -300

FINA 301 Capital Budgeting Exercises | Performance Evaluation|Exercises

 Machine A’s EAC 1,218.14 Machine B’s EAC 1,048.21

Which machine do you choose? Explain.

I choose machine B because machine B’s EAC (1,048.21) is less than machine A’s EAC (1,218.14). Having a lower annual cost is desired over a higher one.

Capital Budgeting Exercise 2

Your company has spent \$250,000 on research to develop a new computer game. The firm is planning to spend \$1,400,000 on a machine to produce the new game. Shipping and installation costs for the new machine total \$200,000 and these costs will be capitalized and depreciated together with the cost of the machine. The machine will be used for 3 years, has a \$200,000 estimated resale value at the end of three years, and will be depreciated straight line over 4 years.  Revenue from the new game is expected to be \$1,200,000 per year, with costs of \$500,000 per year. The firm has a tax rate of 35 percent, a cost of capital (discount rate) of 6 percent, and it expects net working capital (NWC) to increase by \$150,000 at the beginning of the project. This investment in NWC will be wholly recouped at the end of the project.  .

FINA 301 Capital Budgeting Exercises | Performance Evaluation|Exercises

1. Complete the table below.
2. In the second table below calculate the Net Present Value (NPV) of the project.
3. Calculate the Profitability Index (PI) of the project.
4. Is the Internal Rate of Return (IRR) of the project greater than, equal to, or less than the cost of capital (discount rate)?
5. Should your company proceed with this project? Explain based on the decision criteria for NPV, PI, and IRR.
 Year 0 1 2 3 Revenue 1,200,000 1,200,000 1,200,000 Costs (500,000) (500,000) (500,000) Depreciation (400,000) (400,000) (400,000) EBIT 300,000 300,000 300,000 Taxes (105,000) (105,000) (105,000) Net Income 195,000 195,000 195,000 Operating Cash Flow 595,000 595,000 595,000 Change in Net Operating Working Capital (150,000) 150,000 Change in Gross Fixed Assets (1,600,000) 270,000 Total Free Cash Flow (1,750,000) 595,000 595,000 1,015,000
 Net Present Value 193,082.21 Profitability Index 1.11% Internal Rate of Return>, =, or < the cost of capital (discount rate)? Proceed with the project? Explain. Yes, we should proceed with this project because the probability index is greater than zero. Also, the projected cash flows (based on net present value) are worth more than the initial free cash flow.