Discussion

Questions

12-1.

What are the important

administrative considerations in the capital budgeting process?

12-3.

What

are the weaknesses of the payback method?

12-5.

What

does the term mutually exclusive investments mean?

12-6.

How

does the modified internal rate of return include concepts from both the

traditional internal rate of return and the net present value methods?

12-7.

If a corporation has

projects that will earn more than the cost of capital, should it ration

capital?

12-8.

What

is the net present value profile? What three points should be determined to

graph the profile?

12-9.

How

does an asset’s ADR (asset depreciation range) relate to its MACRS category?

Problems

1. Assume a corporation has earnings before

depreciation and taxes of $90,000, depreciation of $40,000, and that it is in a

30 percent tax bracket. Compute its cash flow using the format below.

Earnings before depreciation and taxes _____

Depreciation _____

Earnings before taxes _____

Taxes @ 30% _____

Earnings after taxes _____

Depreciation _____

Cash flow _____

2. a. In problem 1, how much would cash flow be if there were only $10,000

in depreciation? All other factors are the same.

b. How much cash flow is lost due to the reduced depreciation between problems

1 and 2a?

3. Assume a firm has earnings before

depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent

tax bracket.

a. Compute its cash flow.

b. Assume it has $200,000 in depreciation.

Recompute its cash flow.

c. How large a cash flow benefit did the

depreciation provide?

4. Bob Cole, the president of a New York

Stock Exchange-listed firm, is very short term oriented and interested in the

immediate consequences of his decisions. Assume a project that will provide an

increase of $3 million in cash flow because of favorable tax consequences, but

carries a three-cent decline in earning per share because of a write-off

against first quarter earnings. What decision might Mr. Cole make?

5. Assume a $100,000 investment and the

following cash flows for two alternatives.

Year

Investment

A

Investment B

1

$30,000

$40,000

2

50,000

30,000

3

20,000

15,000

4

60,000

15,000

5

50,000

Which

of the two alternatives would you select under the payback method?

6. Assume a $40,000 investment and the

following cash flows for two alternatives.

Year

Investment X

Investment Y

1

$ 6,000

$15,000

2

8,000

20,000

3

9,000

10,000

4

17,000

5

20,000

Which

of the alternatives would you select under the payback method?

7. Referring back to problem 6, if the inflow

in the fifth year for Investment X were $20,000,000 instead of $20,000, would

your answer change under the payback method?

8. The Short-Line Railroad is considering a

$100,000 investment in either of two companies. The cash flows are as follows:

Year

Electric Co.

Water Works

1………………

$70,000

$15,000

2………………

15,000

15,000

3………………

15,000

70,000

4-10………….

10,000

10,000

a. Using the payback method, what will the

decision be?

b. Explain why the answer in part a can be misleading.

9. X-treme Vitamin Company is considering two

investments, both of which cost $10,000. The cash flows are as follows:

Year

Project A

Project B

1……………….

$12,000

$10,000

2……………….

8,000

6,000

3……………….

6,000

16,000

a. Which of the two projects should be chosen

based on the payback method?

b. Which of the two projects should be chosen

based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more

confidence in answer a or answer b?

10. You buy a new piece of equipment for

$16,980, and you receive a cash inflow of $3,000 per year for 12 years. What is

the internal rate of return?

11. Warner Business Products is considering the

purchase of a new machine at a cost of $11,070. The machine will provide $2,000

per year in cash flow for eight years. Warners cost of capital is 13 percent.

Using the internal rate of return method, evaluate this project and indicate

whether it should be undertaken.

12. Elgin Restaurant Supplies is analyzing the

purchase of manufacturing equipment that will cost $20,000. The annual cash

inflows for the next three years will be:

Year

Cash Flow

1…………….

$10,000

2…………….

9,000

3…………….

6,500

a. Determine the internal rate of return

using interpolation.

b. With a cost of capital of 12 percent,

should the machine be purchased?

12-1.What are the important

administrative considerations in the capital budgeting process?12-3.What

are the weaknesses of the payback method?12-5.What

does the term mutually exclusive investments mean?12-6.How

does the modified internal rate of return include concepts from both the

traditional internal rate of return and the net present value methods?12-7.If a corporation has

projects that will earn more than the cost of capital, should it ration

capital?12-8.What

is the net present value profile? What three points should be determined to

graph the profile?12-9.How

does an asset’s ADR (asset depreciation range) relate to its MACRS category?Problems1. Assume a corporation has earnings before

depreciation and taxes of $90,000, depreciation of $40,000, and that it is in a

30 percent tax bracket. Compute its cash flow using the format below.Earnings before depreciation and taxes _____Depreciation _____Earnings before taxes _____Taxes @ 30% _____Earnings after taxes _____Depreciation _____Cash flow _____2. a. In problem 1, how much would cash flow be if there were only $10,000

in depreciation? All other factors are the same. b. How much cash flow is lost due to the reduced depreciation between problems

1 and 2a?3. Assume a firm has earnings before

depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent

tax bracket. a. Compute its cash flow. b. Assume it has $200,000 in depreciation.

Recompute its cash flow. c. How large a cash flow benefit did the

depreciation provide?4. Bob Cole, the president of a New York

Stock Exchange-listed firm, is very short term oriented and interested in the

immediate consequences of his decisions. Assume a project that will provide an

increase of $3 million in cash flow because of favorable tax consequences, but

carries a three-cent decline in earning per share because of a write-off

against first quarter earnings. What decision might Mr. Cole make?5. Assume a $100,000 investment and the

following cash flows for two alternatives.YearInvestment

AInvestment B1$30,000$40,000250,00030,000320,00015,000460,00015,000550,000Which

of the two alternatives would you select under the payback method?6. Assume a $40,000 investment and the

following cash flows for two alternatives.YearInvestment XInvestment Y1$ 6,000$15,00028,00020,00039,00010,000417,000520,000Which

of the alternatives would you select under the payback method?7. Referring back to problem 6, if the inflow

in the fifth year for Investment X were $20,000,000 instead of $20,000, would

your answer change under the payback method?8. The Short-Line Railroad is considering a

$100,000 investment in either of two companies. The cash flows are as follows:YearElectric Co.Water Works1………………$70,000$15,0002………………15,00015,0003………………15,00070,0004-10………….10,00010,000 a. Using the payback method, what will the

decision be? b. Explain why the answer in part a can be misleading.9. X-treme Vitamin Company is considering two

investments, both of which cost $10,000. The cash flows are as follows:YearProject AProject B1……………….$12,000$10,0002……………….8,0006,0003……………….6,00016,000 a. Which of the two projects should be chosen

based on the payback method? b. Which of the two projects should be chosen

based on the net present value method? Assume a cost of capital of 10 percent. c. Should a firm normally have more

confidence in answer a or answer b?10. You buy a new piece of equipment for

$16,980, and you receive a cash inflow of $3,000 per year for 12 years. What is

the internal rate of return?11. Warner Business Products is considering the

purchase of a new machine at a cost of $11,070. The machine will provide $2,000

per year in cash flow for eight years. Warners cost of capital is 13 percent.

Using the internal rate of return method, evaluate this project and indicate

whether it should be undertaken.12. Elgin Restaurant Supplies is analyzing the

purchase of manufacturing equipment that will cost $20,000. The annual cash

inflows for the next three years will be:YearCash Flow1…………….$10,0002…………….9,0003…………….6,500 a. Determine the internal rate of return

using interpolation. b. With a cost of capital of 12 percent,

should the machine be purchased?