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Capital Budgeting

1) Tom Thurlow wants to buy a boat but is short of cash. Two alternatives are available: Tom can accept $2,000 per year from his brother for partial ownership in the boat, or he can earn money by renting the boat to others. Rental income would be $2,500 per year. Under either alternative, the boat will last eight years. If Tom rents the boat out, he will have to pay $3,000 to overhaul the engine at the end of the fourth year.

Which alternative should Tom select, assuming that the cost of capital is 12% and that only quantitative considerations are involved?

2) Net Present Value Used to Rank Alternatives
Taglioni's Pizza Company has to choose a new delivery car from among three alternatives. Assume that gasoline costs $1.30 per gallon and that the firm's cost of capital is 12%. The car will be driven 12,000 miles per year.

Car 1 Car 2 Car 3
Cost 12,000 4,000 8,000
Mileage per gallon 40 8 12
Useful life 5 yrs 5yrs 5yrs
Salvage value 2,000 500 1,000

Required:
1. Which car should the company purchase?
2. How would your answer change if the price of gasoline increased to $2 per gallon?

Solution Preview

Note: For the following answers the abbreviations have the following meanings

PVIF= Present Value Interest Factor
PVIFA= Present Value Interest Factor for an Annuity

They can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%
PVIF( n, r%)= =1/(1+r%)^n

1) Tom Thurlow wants to buy a boat but is short of cash. Two alternatives are available: Tom can accept $2,000 per year from his brother for partial ownership in the boat, or he can earn money by renting the boat to others. Rental income would be $2,500 per year.N Under either alternative, the boat will last eight years. If Tom rents the boat out, he will have to pay $3,000 to overhaul the engine at the end of the fourth year.
Which alternative should Tom select, assuming that the cost of capital is 12% and that only quantitative considerations are involved?

Alternative 1: Accepting $2,000 per year from brother

Since the cash flows are the same over 8 years we can use PVIFA factor to calculate NPV
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

Annual cash flow= $2,000

n= 8
r= 12.00%
PVIFA (8 periods, 12.% rate ) = 4.96764

Annuity= $2,000
Therefore, present value= 9,935 =2000x4.96764

Alternative 2: Accepting $2,500 per year from rental

Since the cash flows are the same over 8 years we can use PVIFA factor to calculate NPV
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

Annual cash flow= $2,500

We first calculate the Present value of $2,500 to be received each year for 8 years
n= 8
r= 12.00%
PVIFA (8 periods, 12.% rate ) = 4.96764

Annuity= $2,500
Therefore, present value= 12,419 =2500x4.96764

We then subtract the present value (PV) of the cost to be incurred at the end of 4 years

n= 4
r= 12.00%
PVIF (4 periods, 12.% rate ) = 0.635518

Future value= 3,000 to overhaul the engine
Therefore, present value= 1,906.55 =3000x0.635518

Therefore present value of alternative 2= 10,512.45 =12419-1906.55

Since the present value of alternative 2 = 10,512.45 is more than the present value of alternative ...

Solution Summary

Answers 2 questions on Capital Budgeting.
1) Choosing between the alternatives: accepting $2,000 per year from his brother for partial ownership in the boat and renting the boat out
2) Net Present Value Used to Rank Alternatives: choose a new delivery car from among three alternatives

$2.19