Capital budgeting decisions are one of the most important issues that managers m

Question

Capital budgeting decisions are one of the most important issues that managers must address. Innovation Corp. is considering the purchase of a corporate jet. The jet will cost $18 million and is expected to reduce travel expense by $3 million annually. The jet has an estimated useful life of 10 years with no salvage value. Innovation Corp. requires a return of 10% to justify investments of this type. Prepare a net present value analysis for the corporate jet. Is this an acceptable investment for Innovation Corp.? Assume that you determine that the corporate jet does not meet the investment criteria established by Innovation Corp. The mangers purchase the jet anyway. Why would managers do this?

Explanation / Answer

(a) (i) This question is solved in two ways, assuming no tax applicable & secon is tax rate @40%.

   (ii) Required rate of return given as 10%, which will be taken the applicable rate for discounting factor.

(iii) Depreciastion is charged on straight line basis.

If there is no tax applicable, the project is viable as NPV is positive, else it is not viable.   

(A) Assuming tax is not applicable Figures in $ million except column a & f Year Cash Flow ($)   Remarks for fund Depre-ciation Taxable profit Cash flow after tax Discounting factor at 7% Discounted Cash Flow ($) a b c d (= b-c) e(= c+d) f g (= e x f) 0    (18.00) Initial outlay (18.00) 1 (18.00) 1       3.00 Cost saving 1.8           1.20           3.00 0.9091               2.73 2       3.00 Cost saving 1.8           1.20           3.00 0.8264               2.48 3       3.00 Cost saving 1.8           1.20           3.00 0.7513               2.25 4       3.00 Cost saving 1.8           1.20           3.00 0.6830               2.05 5       3.00 Cost saving 1.8           1.20           3.00 0.6209               1.86 6       3.00 Cost saving 1.8           1.20           3.00 0.5645               1.69 7       3.00 Cost saving 1.8           1.20           3.00 0.5132               1.54 8       3.00 Cost saving 1.8           1.20           3.00 0.4665               1.40 9       3.00 Cost saving 1.8           1.20           3.00 0.4241               1.27 10       3.00 Cost saving 1.8           1.20           3.00 0.3855               1.16 NPV          0.43

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