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Chapter%20(8)

# Chapter%20(8) - Chapter 8 Fundamentals of Capital Budgeting...

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Chapter 8 Fundamentals of Capital Budgeting Note: A shaded box ( ) indicates problems available in MyFinanceLab. An asterisk (*) indicates problems with a higher level of difficulty. All problems in this chapter are available in MyFinanceLab. An asterisk (*) indicates problems with a higher level of difficulty. 1. Plan: We can compute the total capitalization of the machine by adding the total cost of transporting and installing the machine to the initial cost of purchasing the machine and this will provide us with the total cost of the machine that we must appreciate over the 5 years of the machine’s life. In order to compute the annual depreciation expense of the machine we can then take the total capitalization of the machine and divide it by the depreciable life of the machine. Execute: Capitalization of machine: \$10,050,000 Annual depreciation expense: 10,050,000/5 = \$2,010,000 Evaluate: Rather than expensing the \$10,050,000 it costs to buy, ship, and install the machine in the year it was bought, accounting principles require you to depreciate the \$10,050,000 over the depreciable life of the equipment. Assuming the equipment has a 5-year depreciable life and that we use the straight-line method, we would expense \$10,050,000/5 = \$2,010,000 per year for five years. The idea is to match the cost of acquiring the machine to the timing of the revenues it generates. 2. Plan: We need 4 items to calculate incremental earnings: (1) incremental revenues, (2) incremental costs, (3) depreciation, and (4) the marginal tax rate. Execute: Annual incremental earnings = (Revenues Costs Depreciation) × (1 tax rate) Annual incremental earnings (4 1.2 2.01) (1 0.35) \$513,500 = × = Evaluate: These incremental earnings are an intermediate step on the way to calculating the incremental cash flows that would form the basis of any analysis of the project. The cost of the equipment does not affect earnings in the year it is purchased, but does so through the depreciation expense in the following five years. Note that the depreciable life, which is based on accounting rules, does not have to be the same as the economic life of the asset—the period over which it will have value.

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90 Berk/DeMarzo/Harford • Fundamentals of Corporate Finance 3. Plan: We can compute the incremental revenues by taking the percentage increase in sales of the 100,000 units multiplied by the \$20 sales price per unit. Execute: Incremental revenues (0.20 100,000) \$20 \$400,000 = × × = Evaluate: A new product typically has lower sales initially, as customers gradually become aware of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears obsolescence or faces increased competition. Similarly, the average selling price of a product and its cost of production will generally change over time. Prices and costs tend to rise with the general level of inflation in the economy.
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