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Unformatted text preview: CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 2124 (40 min.) New equipment purchase, income taxes. 1. The aftertax cash inflow per year is $29,600 ($21,600 + $8,000), as shown below: Annual cash flow from operations $ 36,000 Deduct income tax payments (0.40 $36,000) 14,400 Annual aftertax cash flow from operations $ 21,600 Annual depreciation on machine [($88,000 $8,000) 4] $ 20,000 Income tax cash savings from annual depreciation deductions (0.40 $20,000) 8,000 a. Solution Exhibit 2124A shows the NPV computation. NPV = $7,013 b. Payback = $88,000 $29,600 = 2.97 years c. Solution Exhibits 2124B and 2124C report the net present value of the project using 14% (small positive NPV) and 16% (small negative NPV). The IRR, the discount rate at which the NPV of the cash flows is zero, must lie between 14% and 16%. By interpolation: Internal rate of return = $763 16% 2% $763 $2,960 + = 15.59% 2. Both the net present value and internal rate of return methods use a discounted cash flow approach in which all expected future cash inflows and cash outflows of a project are measured as if they occurred at a single point in time. The payback method considers only cash flows up to the time when the expected future cash inflows recoup the net initial investment in a project. The payback method ignores profitability and the time value of money. However, the payback method is becoming increasingly important in the global economy. When the local environment in an international location is unstable and therefore highly risky for a potential investment, a company would likely pay close attention to the payback period for making its investment decision. In general, the more unstable the environment, the shorter the payback period desired. SOLUTION EXHIBIT 2124A Present Value Total Discount Present Factor Value at 12% Sketch of Relevant AfterTax Cash Flows 0 1 2 3 4 1a. Initial machine investment $(88,000) 1.000 $(88,000) 1b. Initial working capital investment 0 1.000 $0 2a. Annual aftertax cash flow from operations (excl. depr.) Year 1 19,289 0.893 $21,600 Year 2 17,215 0.797 $21,600 Year 3 15,379 0.712 $21,600 Year 4 13,738 0.636 $21,600 2b. Income tax cash savings from annual depreciation deductions Year 1 7,144 0.893 $8,000 Year 2 6,376 0.797 $8,000 Year 3 5,696 0.712 $8,000 Year 4 5,088 0.636 $8,000 3. Aftertax cash flow from: a. Terminal disposal of machine...
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 Spring '11
 GALVEN

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