Exercises Ch. 7 - Capital Budgeting - A

Exercises on Ch.
1. A Corporation is studying a project that would have a ten-year life and would require a
$450,000 investment in equipment which has no salvage value. The project would provide net
operating income each year as follows for the life of the project (Ignore income taxes.):
Sales $ 500,000
Less variable expenses 200,000
Contribution margin 300,000
Less fixed expenses:
Fixed expenses $ 150,000
Depreciation expenses 45,000 195,000
Net operating income $ 105,000
The company's required rate of return is 12%. The payback period for this project is
closest to:
A) 3 years
B) 2 years
C) 4.28 years
D) 9 years

Add: Noncash deduction for depreciation 45,000
Annual net cash inflow $ 150,000
Payback period = Investment required ÷ Annual net cash inflow

= $450,000 ÷ $150,000 per year = 3 years
2. A Corporation is considering a capital budgeting project that would require an initial

investment of $350,000. The investment would generate annual cash inflows of $133,000 for
the life of the project, which is 4 years. At the end of the project, equipment that had been used
in the project could be sold for $32,000. The company's discount rate is 14%. Using the
relevant present value table, the net present value of the project is closest to:
A) $214,000
B) $37,429
C) $56,373
D) $406,373
Year
Now 1 2 3 4
Initial $ (350,000 )
investment
Annual net $ 133,000 $ 133,000 $ 133,000 $ 133,000
cash flow
Salvage $ 32,000
value
Page 1 of 5
Total cash $ (350,000 ) $ 133,000 $ 133,000 $ 133,000 $ 165,000
flows (a)
Discount 1.000 0.877 0.769 0.675 0.592
factor
(14%) (b)
Present $ (350,000) $ 116,641 $ 102,277 $ 89,775 $ 97,680
value of
cash flows
(a) × (b)
Net present $ 56,373
value
3. The management of a corporation is considering the purchase of a machine that would cost
$440,000, would last for 7 years, and would have no salvage value. The machine would reduce
labor and other costs by $102,000 per year. The company requires a minimum pretax return of
16% on all investment projects. Using the relevant present value table, the net present value of
the project is closest to (Ignore income taxes):
A) $(28,022)
B) $96,949
C) $(79,196)
D) $274,000
Year
Now 1-7
Initial investment $ (440,000 )
Annual net cash flow $ 102,000
Total cash flows (a) $ (440,000 ) $ 102,000
Discount factor (16%) (b) 1.000 4.039
Present value of cash flows (a) × (b) $ (440,000) $ 411,978
Net present value $ (28,022)
4. A Corporation is considering an investment in a machine. The machine will cost $240,000,

will last 10 years, and will have a $40,000 salvage value at the end of 10 years. The machine
is expected to generate net cash inflows of $60,000 per year in each of the 10 years. The
discount rate is 18%. Using the relevant present value table, the net present value of the
proposed investment is closest to (Ignore income taxes):
A) $5,840
B) $37,280
C) $(48,780)
D) $69,640
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Year
Now 1-10 10
Initial investment $ (240,000 )
Salvage value $ 40,000
Total cash flows (a) $ (240,000 ) $ 60,000 $ 40,000
Discount factor (18%) (b) 1.000 4.494 0.191
Present value of cash flows
(a) × (b) $ (240,000) $ 269,640 $ 7,640
Net present value $ 37,280
5. A Corporation is considering a machine that will save $9,000 a year in cash operating costs
each year for the next six years. At the end of six years it would have no salvage value. If this
machine costs $33,165 now. Using the relevant present value table, the machine's internal rate
of return is closest to (Ignore income taxes):
A) 16%
B) 17%
C) 18%
D) 19%
Factor of the internal rate of return = Investment required ÷ Annual net cash inflow
= $33,165 ÷ $9,000 = 3.685
This factor is the present value of an annuity for 6 periods at 16% per period.
6. Given the following data (Ignore income taxes):
Cost of equipment $ 48,680

Annual cash inflows $ 10,000
Internal rate of return 10 %
Using the relevant present value table, the life of the equipment must be:
A) It is impossible to determine from the data given

B) 5 years
C) 6 years
D) 7 years
Factor of the internal rate of return = Investment required ÷ Annual net cash inflow
= $48,680 ÷ $10,000 = 4.868

Looking down the 10% column on the table for the Present Value of an Annuity, 4.868 is the
present value of a 7-year annuity. Therefore, the life of the equipment must be 7 years.
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7. The management of A Corporation is investigating purchasing equipment that would increase
sales revenues by $269,000 per year and cash operating expenses by $156,000 per year. The
equipment would cost $294,000 and have a 6-year life with no salvage value. The simple rate
of return on the investment is closest to (Ignore income taxes):
A) 16.7%
B) 38.4%
C) 23.8%
D) 21.8%
Annual incremental sales revenue $ 269,000

Annual incremental expenses:
Annual cash operating expenses $ 156,000
Annual depreciation ($294,000 – $0)/6 $ 49,000 205,000
Annual incremental net operating income $ 64,000
Simple rate of return = Annual incremental net operating income ÷ Initial investment
= $64,000 ÷ $294,000 = 21.8% (rounded)
8. A company is considering a project that would have a ten-year life and would require a
$1,000,000 investment in equipment. At the end of ten years, the project would terminate and
the equipment would have no salvage value. The project would provide net operating income
each year as follows (Ignore income taxes):
Sales $ 2,000,000
Variable expenses 1,400,000
Contribution margin 600,000
Fixed expenses:
Fixed out-of-pocket cash expenses $ 300,000
Depreciation 100,000 400,000
All of the above items, except for depreciation, represent cash flows. The company's required
rate of return is 12%.
Using present value tables to determine the appropriate discount factor(s).
Required:
a. Compute the project's net present value.
b. Compute the project's internal rate of return to the nearest whole percent.
c. Compute the project's payback period.
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d. Compute the project's simple rate of return.
a.
Because depreciation is the only noncash item on the income statement, the annual net cash flow
can be computed by adding back depreciation to net operating income.

Depreciation 100,000
Annual net cash inflow $ 300,000
Year
Now 1-10
Initial investment $ (1,000,000 )
Total cash flows (a) $ (1,000,000 ) $ 300,000
Discount factor (12%) (b) 1.000 5.650
Present value of cash flows (a) × (b) $ (1,000,000) $ 1,695,000
Net present value $ 695,000
b.
The formula for computing the factor of the internal rate of return (IRR) is:
Factor of the IRR = Investment required ÷ Annual net cash inflow
= $1,000,000 ÷ $300,000 = 3.333
This factor is closest to the present value of an annuity over 10 years at 27%.
c.
The formula for the payback period is:
Investment required ÷ Annual net cash inflow = Payback period
$1,000,000 ÷ $300,000 per year = 3.33 years
d.
The formula for the simple rate of return is:
Simple rate of return = Net operating income ÷ Initial investment
= $200,000 ÷ $1,000,000 = 20.0%
Page 5 of 5

Exercises Ch. 7 - Capital Budgeting - A

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Exercises on Ch.

Net operating income $ 105,000

Payback period = Investment required ÷ Annual net cash inflow

2. A Corporation is considering a capital budgeting project that would require an initial

4. A Corporation is considering an investment in a machine. The machine will cost $240,000,

6. Given the following data (Ignore income taxes):

Cost of equipment $ 48,680

A) It is impossible to determine from the data given

= $48,680 ÷ $10,000 = 4.868

Annual incremental sales revenue $ 269,000

= $64,000 ÷ $294,000 = 21.8% (rounded)

Using present value tables to determine the appropriate discount factor(s).

c. Compute the project's payback period.

Net operating income $ 200,000

Factor of the IRR = Investment required ÷ Annual net cash inflow

= $1,000,000 ÷ $300,000 = 3.333

Investment required ÷ Annual net cash inflow = Payback period

$1,000,000 ÷ $300,000 per year = 3.33 years

Simple rate of return = Net operating income ÷ Initial investment

= $200,000 ÷ $1,000,000 = 20.0%

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