# Capital Budgeting Decisions Problems

Ex. 12-7

Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous are. The tract contains a mineral deposit that the company believes might be commercially attractive to mine and sell. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with operating a mine in the area:

Cost of equipment required $850,000

Net annual cash receipts $230,000*

Working Capital required $100,000

Cost of road repairs in three years 60,000

Salvage value of equipment in five years $200,000

It is estimated that the mineral deposit would be exhausted after five years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company's required rate of return is 14%.

Required:

Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

Ex. 12-9

Lake Union Yacht Brokers is investigating five different investment opportunities. Information on the five projects under study is given on the next page:

Project Number

1 2 3 4 5

Investment required $(480,000) $(360,000) $(270,000) $(450,000) $(400,000)

Present value of cash inflows at a 10% discount rate

567,270

433,400

336,140

522,970

379,760

Net present value

$87,270

$73,400

$66,140

$72,970

$(20,240)

Life of the project

6 years

12 years

6 years

3 years

5 years

Since the company's required rate of return is 10%, a 10% discount rate has been used in the present value computations above. Limited funds are available for investment, so the company can't accept all of the available projects.

Required:

1. Compute the profitability index for each investment project.

2. Rank the five projects according to preference, in terms of:

a. net present value

b. profitability index

3. Which ranking do you prefer? Why?

Prob 12-17

Otthar's Amusement Center contains a number of electronic games as well as a miniature gold course and various rides located outside the building. Otthar Luvinson, the owner, would like to construct a water slide on one portion of his property. Otthar has gathered the following information about the slide:

a. Water slide equipment could be purchased and installed at a cost of $500,000. The slide would be usable for 10 years, after which it would have no salvage value.

b. Otthar would use straight-line depreciation on the slide equipment.

c. To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $40,000 to an amusement park in a nearby city.

d. Otthar has concluded that water slides would increase ticket sales by $320,000 per year.

e. Based on experience at other water slides, Otthar estimates that incremental operating expenses each year for the slide would be: salaries, $115,000; insurance, $28,200; utilities, $12,000; and maintenance, $32,000.

Required:

1. Prepare an income statement showing the expected net operating income each year from the water slide.

2. Compute the simple rate of return expected from the water slide. Based on this computation, would the water slide be constructed if Otthar requires a simple rate of return of at least 15% on all investments?

3. Compute the payback period for the water slide. If Otthar requires a payback period of 5 years or less, would the water slide be constructed?

12-19

Anita Vasquez received $160,000 from her mother's estate. She placed the funds into the hands of a broker, who purchased the following securities on Anita's behalf:

a. Common stock was purchased at a cost of $80,000. The stock paid no dividend, but it was sold for $180,000 at the end of 4 years.

b. Preferred stock was purchased at its par value of $30,000.The stock paid a 6% dividend (based on par value) each year for years. At the end of 4 years, the stock was sold for $24,000.

c. Bonds were purchased at a cost of $50,000. The bonds paid $3,000 in interest every six months. After 4 years, the bonds were sold for $58,500. (Note: in discounting a cash flow that occurs semi-annually, the procedure is to halve the discount rate and double the number of periods. Use the same procedure in discounting the proceeds from the sale.)

The securities were all sold at the end of four years so that Anita would have funds available to start a new business venture. The broker stated that the investments had earned more than 20% return, and he gave Anita the following computation to support his statement:

Common stock:

Gain on sale ($180,000-$80,000) $100,000

Preferred stock:

Dividends paid (6% * $30,000 * 4 years) 7,200

Loss on sale ($24,000-$30,000) (6,000)

Bonds:

Interest paid ($3,000 * 8 periods) 24,000

Gain on sale ($58,500 - $50,000) 8,500

Net gain on all investments $133,700

$133,700 divided by 4 years =20.9%

$160,000

Required:

1. Using a 20% discount rate, compute the net present value of each of the three investments. On which investment (s) did Anita earn a 20% rate of return? (Round computations to the nearest whole dollar.)

2. Considering all three investments together, did Anita earn a 20% rate of return? Explain.

3. Anita wants to use the $262,500 proceeds ($180,000 + $24,000 +$58,500 = $262,500) from sale of the securities to open a fast-food franchise under a 10-year contract. What net annual cash inflow must the store generate for Anita to earn a 16% return over the 10-year period? Assume that Anita will not receive back her original investment at the end of the contract. (Round computations to the nearest whole dollar.)

Analytical Thinking (LO1)

Wyndham Stores operates a regional chain of upscale department stores. The company is going to open another store soon in a prosperous and growing suburban area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Harry Wilson, the company's marketing vice president, stated, "I know most of our competitors are starting to lease facilities, rather than buy, but, I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for $14 million. They also say that property taxes, insurance, maintenance, and repairs would run $200,000 a year. When you figure that we plan to keep a site for 20 years, that's a total cost of $18 million. But then when you realize that the building and property will be worth at least $5 million in 20 years, that's a net cost to us of only $13 million. Leasing costs a lot more than that." "I'm not so sure," replied Erin Reilly, the company's executive vice president. "Guardian Insurance Company is willing to purchase the building site, construct a building and install fixtures to our specifications, and then lease the facility to us for 20 years for an annual lease payment of only $1 million.

"That's just my point," said Henry. "At 1 million a year, it would cost us $20 million over the 20 years instead of just $13 million. And what would we have left at the end? Nothing! The building would belong to the insurance company! I'll bet they would even want the first lease payment in advance." "That's right," replied Erin. "We would have to make the first payment immediately and then one payment at the beginning of each of the following 19 years. However, you're overlooking a few things. For one thing, we would have to tie up a lot of our funds for 20 years under the purchase alternative. We would have to put $6 million down immediately if we buy the property, and then we would have to pay the other $8 million off over four years at $2 million a year." "But that cost is nothing compared to $20 million for leasing," said Harry. "Also, if we lease, I understand we would have to put up a $400,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all repairs and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this." "Well, I'll admit that I don't have all the figures sorted out yet," replied Erin. "But I do have the operating cost breakdown for the building, which includes $90,000 annually for property taxes, $60,000 for insurance, and $50,000 for repairs and maintenance. If we lease, Guardian will handle its own insurance costs and will pay the property taxes, but we'll have to pay for the repairs and maintenance. I need to put all this together and see if leasing makes any sense with our 12% before-tax required rate of return. The president wants a presentation and recommendation in the executive committee meeting tomorrow."

Required:

1. Using the net present value approach, determine whether Wyndham Stores should lease or buy the new store. Assume that you will be making your presentation before the company's executive committee and remember that the president detests sloppy, disorganized reports.

2. What reply will you make in the meeting if Harry Wilson brings up the issue of the building's future sales value?

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Ex. 12-7

Renfree Mines, Inc., owns the mining rights to a large tract of land in a mountainous are. The tract contains a mineral deposit that the company believes might be commercially attractive to mine and sell. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with operating a mine in the area:

Cost of equipment required $850,000

Net annual cash receipts $230,000*

Working Capital required $100,000

Cost of road repairs in three years 60,000

Salvage value of equipment in five years $200,000

It is estimated that the mineral deposit would be exhausted after five years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company's required rate of return is 14%.

Required:

Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

Year 0

Cost of equipment required $850,000

Working Capital required $100,000

Total Initial investment $950,000

Year 1 2 3 4 5

Net cash receipts $230,000 $230,000 $230,000 $230,000 $230,000

Less: Road repairs (60,000)

Add: Working Capital $100,000

Salvage value of equipment $200,000

Net cash inflow $230,000 $230,000 $170,000 $230,000 $530,000

NPV = sum of CFt where CF is the cash flow

(1 + k)t k is the cost of capital

t is the period.

NPV = -950,000 + 230,000 + 230,000 + 170,000 + 230,000 + 530,000

(1.14)1 (1.14)2 (1.14)3 (1.14)4 (1.14)4

NPV = - 45,079

The project should not be accepted because the NPV is negative.

Ex. 12-9

Lake Union Yacht Brokers is investigating five different investment opportunities. Information on the five projects under study is given on the next page:

Project Number

1 2 3 4 5

Investment required $(480,000) $(360,000) $(270,000) $(450,000) $(400,000)

Present value of cash inflows at a 10% discount rate

567,270

433,400

336,140

522,970

379,760

Net present value

$87,270

$73,400

$66,140

$72,970

$(20,240)

Life of the project

6 years

12 years

6 years

3 years

5 years

Since the company's required rate of return is 10%, a 10% discount rate has been used in the present value computations above. Limited funds are available for investment, so the company can't accept all of the available projects.

Required:

1. Compute the profitability index for each investment project.

Profitability index = PV benefits/PV costs

1 2 3 4 5

PI = 567,270 433,400 336,140 522,970 379,760

480,000 360,000 270,000 450,000 400,000

PI = 1.18 1.20 1.24 1.16 0.95

2. Rank the five projects according to preference, in terms of:

a. net present value

Project 1 2 4 3 5

b. profitability index

Project 3 2 1 4 5

3. Which ranking do you prefer? Why?

I would prefer using profitability index and choose Project 3 because the profitability index indicates the benefits return received per $1 of initial investment.

Prob 12-17

Otthar's Amusement Center contains a number of electronic games as well as a miniature gold course and various rides located outside the building. Otthar Luvinson, the owner, would like to construct a water slide on one portion of his property. Otthar has gathered the following information about the slide:

a. Water slide equipment could be purchased and installed at a cost of $500,000. The slide would be usable for 10 years, after which it would have no salvage value.

b. Otthar would use straight-line depreciation on the slide equipment.

c. To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $40,000 to an amusement park in a nearby city.

d. Otthar has concluded that water slides would increase ticket sales by $320,000 per year.

e. Based on experience at other water slides, Otthar estimates that incremental operating expenses each year for the slide would be: salaries, $115,000; insurance, $28,200; utilities, $12,000; and ...

#### Solution Summary

This solution is comprised of a detailed explanation and calculations to answer the capital budgeting decisions problems.

Geico Problem: Capital Budgeting Decisions

Geico

Geico is considering expanding an existing plant on a piece of land it already owns. The land was purchased 15 years ago for $325,000, and its current market appraisal is $820,000. A capital budgeting analysis shows that the plant expansion has a net present value of $130,000. The expansion will cost $1.73 million, and the discounted cash inflows are $1.86 million. The expansion cost of $1.73 million does not include any provision for the cost of the land. The manager preparing the analysis argues that the historical cost of the land is a sunk cost, and since the firm intends to keep the land whether or not the expansion project is accepted, the current appraisal value is irrelevant.

Should the land be included in the analysis? If so, how?

Housing Markets

A home identical to yours in your neighborhood, sold last week for $150,000. Your home has a $120,000 assumable, 8% mortgage (compounded annually) with 30 years remaining. An assumable mortgage is one that the new buyer can assume at the old terms, continuing to make payments at the original interest rate. The house that recently sold did not have an assumable mortgage; that is, the buyers had to finance the house at the current market rate of interest, which is 15%. What price should you ask for your home?

A third home, again identical to the one that sold for $150,000, is also being offered for sale. The only difference between this third home and the $150,000 home is the property taxes. The $150,000 home's property taxes are $3,000 per year, while the third home's property taxes are $2,000 per year. The differences in the property taxes are due to vagaries in how the property tax assessors assessed the taxes when the homes were built. In this tax jurisdiction, once annual taxes are set, they are fixed for the life of the home. Assuming the market rate of interest is still 15%, what should be the price of this third home?

Mortgage Department

Suppose you are the manager of a mortgage department at a savings bank. Under the state usury law, the maximum interest rate allowed for mortgages is 10% compounded annually.

a. If you granted a $50,000 mortgage at the maximum rate for 30 years, what would be the equal annual payments?

b. If the current market internal rate on similar mortgages is 12%, how much money does the bank lose by issuing the mortgage described in (a)?

c. The usury law does not prohibit banks from charging points. One point means that the borrower pays 1% of the $50,000 loan back to the lending institution at the inception of the loan. That is, if one point is charged, the repayments are computed as in (a), but the borrower receives only $49,500. How many points must the bank charge to earn 12% on the 10% loan?

Watson's Bay

Watson's Bay Co. is considering a contract to manufacture didgeridoos. Producing didgeridoos will require an investment in equipment of $100,000 and operating costs of $15 per didgeridoo produced. The contract calls for the company to deliver 2,000 didgeridoos a year for each of 4 years at a price of $30 per didgeridoo. At the end of 4 years the equipment is expected to be sold for $10,000. The equipment will be depreciated as follows:

Year Depreciation Factor

1 0.3333

2 0.4445

3 0.1481

4 0.0741

The depreciation factor is applied to the full cost of the equipment (i.e., salvage value is not considered when depreciation is determined). The tax rate is 33%, and the market rate of return for investments of this risk is 20%. Should Watson's Bay Co. take the contract to manufacture didgeridoos?

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