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Capital Budgeting Techniques

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Company currently has sales of 1,400,000 per yr. It's considering an add'l new office machine, which will not result in any new sales but will save the company 105,500 before taxes per yr over its 5 yr useful life. The machine will cost 300,000 plus another 12,000 for installation. The new asset will be depreciated using a modified accelerated cost recovery system (MACRS) 5 yr class life. It will be sold for 25,000 at the end of 5 years. Add'l inventory of 11,000 will be required for parts and maintenance of new machine. The company evaluates all projects at this risk level using an 11.99% required rate return. Tax rate is expected to be 35% for the next decade.

1. What is the total investment in the new machine at time = 0 (T=0)?
2. What are the net cash flows in each of the 5 years of operation?
3. What are the terminal cash flows from the sale of the asset at the end of the 5 yrs?
4. What is the NPV of the investment?
5. What is the IRR of the investment?
6. What is the payback period for the investment?
7. What is the profitability index for the investment?
8. Based on the decision rules for the NPV and those of IRR, is the project acceptable?
9. Is there a conflict between the two decision methods?
10. What are the pros and cons of the NPV and the IRR?

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Solution Summary

Solution depicts the steps to estimate the NPV, IRR, and PI for the given case.

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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