CAPITAL BUDGETING
The Problem
Step 1:
Computing the Incremental Cash Flows
Step 2:
Computing the Initial Outlay
Step 3:
Computing the NPV and IRR
The Problem
Old equipment: book value = $600,000 with a remaining life of 5 years
Expected salvage value in 5 years = 0
Market value today = $265,000
Straight-line depreciation
New equipment: purchase price = $1,175,000 and a MACRS life of 5 years
Expected salvage value in 5 years = $145,000
Annual savings = $255,000
Other information: 40% marginal tax rate and a 12% hurdle rate
Step 1: Incremental Cash Flows
∆
CF = (
∆
S -
∆
C -
∆
D)(1 - t) +
∆
D
Let's first find
∆
D. The depreciation on the old equipment is easy since it's straight-line. D = 600000/5 =
120000 per year. The new machine is being depreciated using MACRS and it's in the 5 year class. Look in
the text for a table of the percentages to use each year. For a 5 year asset, the percentages are 20%, 32%,
19%, 12% and 11%. That's a total of 94%. That means the book value at the end of the 5th year is 6%.
Remember, with MACRS a 5 year asset really means 5.5 years and the remaining 6% is a half year's
depreciation. Applying these rates to the price of 1,175,000 gives the following annual depreciation for the
new equipment: .20*1,175,000 = 235,000; .32*1,175,000 = 376,000; .19*1,175,000 = 223,250; .
12*1,175,000 = 141,000; .11*1,175,000 = 129,250 with a remaining book value of .06*1,175,000 = 70,500.
Merely subtract the depreciation on the old equipment of $120,000 from the depreciation on the new
equipment to get each year's
∆
D.
YEAR