Capital Budgeting Capital budgeting is a widely used financial tool based on the

Question

Capital Budgeting

            Capital budgeting is a widely used financial tool based on the time value of money (discounted cash flows). The idea is that money in hand today is worth more than money received tomorrow. Using this foundation, capital budgeting balances inflows with outflows over time to determine the net present value of an investment or its internal rate of return. Inherent in the use of capital budgeting is the need for management to establish some form of hurdle rate, which is a measure of the value of money over time. The hurdle rate is usually composed of at least three elements: 1) an interest charge or opportunity cost, 2) a measure of return above the interest charge, and 3) a measure of risk. A prominent challenge to the use of capital budgeting is that it is information dependent, especially with respect to estimating cash flows. A second drawback to using capital budgeting is that it does not take into account qualitative or strategic issues. Thus, combining capital budgeting with a weighted-factor approach can be very useful in making investment decisions.

Problem

Savage Manufacturing is trying to decide whether to invest in a new CAD system for the design of its new front discharge concrete truck. The initial purchase price for the CAD system from ComputerGlow Graphics would be $12,500 for the hardware, software, and initial setup cost. An additional $2,500 would be required to rewire the drafting office for the CAD system. This CAD system is expected to reduce design times as well as reducing duplication, reducing engineering changeovers, and improving overall product quality. The marketing and accounting departments have provided the following estimates for the after-tax cash flows for the expected savings from the CAD system over its five-year life.

            Year                             After-tax Cash Flow

            1                                         $5,500

            2                                           4,000

            3                                           4,500

            4                                           3,500

            5                                           6,000

                                                                                                                                    Your Answer

With an established policy of only adopting investments that

provide an 18% return, should the CAD system be purchased?                                                       

What is the NPV for this potential investment?                                                                                 

What is the IRR?                                                                                                                              

What would the NPV be if a salvage value of $650 was expected?                                                  

Should Savage purchase the CAD system now? (consider the question carefully)                            

What is the discount factor for the 5th year if a hurdle rate is 35 percent?

Explanation / Answer

To compute NPV, we need to multiply the after-tax cash flows of each year with their respective discount factors @18%.

Discount factor = 1 / (1 + r)n

where, r = discount rate, n = year for which it is computed

Year 1 discount factor = 1 / (1 + 0.18)1 = 0.84745762711

Year 2 discount factor = 1 / (1 + 0.18)2 = 0.71818442975

Year 3 discount factor = 1 / (1 + 0.18)3 = 0.60863087266

Year 4 discount factor = 1 / (1 + 0.18)4 = 0.51578887513

Year 5 discount factor = 1 / (1 + 0.18)5 = 0.43710921621

NPV

Initial Cost = $12,500 + $2,500 = $15,000

NPV = Present Value of Cash inflows - initial cost = $14,700.51 - $15,000 = (-)$299.49

The CAD system should not be purchased since NPV is negative.

IRR

IRR is the rate at which present value of cash inflows is equal to the intial cost or the rate at which NPV is zero. To compute IRR, we need to compute NPV at two different rates and then interpolate them. We have already computed NPV at 18%. Remember, the closer the rates, the more accurate will be the IRR. We should choose a rate that would turn the NPV positive (or negative in case above NPV was positive). Let's try at 17%.

NPV = Present Value of Cash inflows - initial cost = $15,037.02 - $15,000 = $37.02

Now, we need to interpolate -

Difference required = $299.49

Total difference (between 17% and 18%) = $299.49 + $37.02 = $336.51

IRR = Lower rate + Difference in rates x (Difference required / Total difference)

or, IRR = 17% + 1% x ($299.49 / $336.51) = 17.89%

NPV in case of $650 salvage value

We need to multiply the salvage value with the discount factor of year 5 @18% and add it to the NPV previously computed.

NPV = (-)$299..49 + $650 x 0.43710921621 = (-)$15.37

No, it should still not be purchased.

Discount factor

Discount factor @35% for year 5 = 1 / (1 + 0.35)5 = 0.223013502

Year Cash Flow Discount Factor Present Value 1 $5500 0.84745762711 $4,661.02 2 $4000 0.71818442975 $2,872.73 3 $4500 0.60863087266 $2,738.84 4 $3500 0.51578887513 $1,805.26 5 $6000 0.43710921621 $2,622.66 Total $14,700.51

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.