August

FUNDAMENTAL OF FINANCIAL MANAGEMENT

2, 2024
TUTORIAL: CAPITAL BUDGETING

1. Textbook, Chapter 8: 18,19, 21, 24, 25, 26, 30, 34, 36 p.264
2. You have been considering going into business for some time and have been on the look-
out for opportunities. You decide that West End is desperately in need of a gourmet pizza
shop. You have made a series of enquiries, obtained relevant quotes, and compiled the
following data:

v A shop can be leased for $800 per month payable in arrears. All fittings would have to be
purchased. These include:
o A wood-fired pizza oven at a cost of $5,000
o An industrial fridge/freezer at a cost of $7,000
o A smoke/burglar alarm at a cost of $2,000
o Miscellaneous cooking utensils at a cost of $10,000
v All assets purchased will be depreciated (straight line) over a five-year useful life down to
a salvage value of zero.
v The following data are relevant for estimating cash inflows and outflows. All figures are
on a monthly basis:
o Sales: 700 pizzas at an average price of $12,
o Sales: you anticipate that every second pizza will also order a one-liter soft drink.
Your profit on soft drink is $1.50 per bottle,
o Costs: ingredients estimated at $3 per pizza,
o Advertising in letterboxes and newspapers, $500 o Electricity and telephone, $800
o Casual wages, $3,000
o Don’t forget the lease cost!
v Other miscellaneous items are:
o You will offer free delivery of pizzas to surrounding suburbs. This will be done in
your own car, which was purchased (for private use) three years ago at a cost of
$50,000. The car is currently valued at $30,000 and has an estimated remaining life
of five years. You figure that business use of the car will amount to about 50% of
the car’s total use, and that the business share of running expenses will amount to
$3,000 per year (including additional petrol). For tax purposes, you will depreciate
the car to a zero-salvage value over its remaining life. If you decide not to start the
pizza shop, you will just continue using the car for personal use.
o The above-mentioned advertising will only be conducted in the first 2 years of the
business. After that, you hope to have sufficient repeat business and word-of-mouth
to maintain your sales at forecasted levels.
o To establish the business, you will inject working capital of $20,000. This money
will be recovered on closure of the business in five years.
o You expect to pay tax at an average rate of 20%. Assume tax is paid at the end of
each year.

Since the equipment has a five-year useful life, you are looking at this being a five-year
project, after which you will move on to something else. Although many of the above
estimates are on a monthly basis, you will “do the math” by aggregating all figures to get

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2, 2024
yearly estimates.
REQUIRED:

A. Calculate the expected annual after-tax cash flows over the five-year life of the business.
B. You are unsure of what discount rate to apply to these cash flows. Your forecasts of sales
and costs are pretty rough. Prepare an NPV profile to gauge the sensitivity of the NPV to
discount rate.
C. Finally, you conclude that a 25% p.a. discount rate is applicable for this line of business.
Should you go ahead and establish the gourmet pizza shop?

4. The Outback Mining Company has constructed a town at Big Bore, near the site of a rich
mineral discovery in a remote part of Australia. The town will be abandoned when mining
operations cease after an estimated 10- year period. The following estimates of investment
costs, sales and operating expenses relate to a project to supply Big Bore with meat and
agricultural produce over the 10-year period by developing nearby land:

v Investment in land is $1 million, farm buildings $200,000, and farm equipment $400,000.
The land is expected to have a realizable value of $1 million in 10 years’ time. The salvage
value of the buildings after 10 years is expected to be $50,000. The farm equipment has an
estimated life of 10 years and a zero-salvage value.
v An investment of $250,000 in current assets is required at startup. This working capital
will be recovered at the termination of the venture.
v Annual cash sales are estimated to be $2.48 million.
v Annual cash operating costs are estimated to be $2.2 million.
Is this project profitable, given that the required rate of return is 10% p.a.? The applicable
tax rate is 30%. Note that investments in land and working capital are not depreciable.
Assume that buildings and equipment are depreciable straight line over their useful lives.

5. The Andy Aghastli Company (AAC) designs a range of eye-catching fluorescent tennis
clothing. The designers have always hand-drawn and painted their new fashion ranges. The
owner, Mr Aghastli, is considering purchasing a new computer-aided design (CAD)
package to allow his designers to create their designs on computers. The CAD project is
expected to generate cost savings by improving productivity. Also, AAC can submit
electronic templates of its latest designs to the manufacturers of its fashion ranges, which
would also generate significant savings. The up-front hardware and software cost to AAC
is estimated at $300,000. The computers and software have a 5-year useful life. After that,
the technology will be obsolete and will have no salvage value. The CAD project is
expected to save AAC approximately $88,000 (after tax) per annum. REQUIRED:

Advise Mr Aghastli on the acceptability of the CAD proposal, applying the following
capital budgeting methods:

a. Net Present Value,

b. Internal Rate of Return.

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Assume that all cash flows occur at the end of each period, with the exception of the up-
front outlay, which is paid at the commencement of the project. Assume that AAC’s
required rate of return on this project is 10% p.a.

6. Your office is about to purchase a new machine at a cost of $64,000. You have forecast the
following data relating to the salvage value and maintenance costs over the next five years.

Year Salvage value at the end of each year ($) Annual maintenance expense ($)
1 50,000 11,000
2 40,000 13,000
3 30,000 18,000
4 23,000 24,000
5 3,500 28,000

has a 28% tax rate and a 15% p.a. required return on this project, and use straight-line depreciation.
Should the office replace a machine every year, or every three years, or every five years?

7. Kalorie Cola is considering buying a special-purpose bottling machine for $28,000. It is

expected to have a useful life of 7 years with a zero-disposal price. The plant manager
estimates the following savings in cash- operating costs:

YEAR AMOUNT
1 $10,000
2 $8,000
3 $6,000
4 $5,000
5 $4,000
6 $3,000
7 $3,000
Total $39,000

The Plant Manager argues that, since the total cash savings ($39,000) exceed the outlay ($28,000),
Kalorie Cola should definitely purchase the machine.

REQUIRED:

a. Calculate whether the bottling machine should be purchased according to the following
methods: (i) Net Present Value, and (ii) Internal Rate of Return. Kalorie Cola’s required
rate of return is 16% p.a.

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b. Explain to the Plant Manager why his logic for purchasing the machine is flawed. Why
can’t we compare the total cash savings with the machine cost