Solutions Manual CHAPTER 28
BASI CSOFCAPI TALBUDGETI NG
SUGGESTED ANSWERS TO THE R EVIEW EVIEW QUESTIONS AND PROBLEMS I.
Questions
1. Only cash cash can be spent spent or reinvest reinvested, ed, and since since account accounting ing profits profits do not not necessarily represent all cash, they are of less fundamental importance than cash flows for investment analysis. 2. Capital Capital budgeting budgeting analys analysis is should should only includ includee those cash cash flows that that will be affected by the decision. Sunk costs are costs are unrecoverable and cannot be changed, changed, so they have no bearing on the capital budgeting budgeting decision. decision. Opportunity costs represent costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative to other projects that result from the firm underta! underta!ing ing this project. project. "hese "hese cash flows occur occur only because the firm too! on the capital budgeting project# therefore, they must be included in the analysis. $. %hen a firm firm ta!es ta!es on a new capit capital al budgeting budgeting project, project, it typical typically ly must must increase its investment in receivables and inventories, over and above the increa increase se in payabl payables es and accrua accruals, ls, thus thus increa increasin sing g its net opera operatin ting g wor!ing capital (&O%C. 'ince this increase must be financed, it is includ included ed as an outflow outflow in e ear ) of the analysis analysis.. *t the end of the project+s life, inventories are depleted and receivables are collected. "hus, there is a decrease (or reduction in &O%C, which represents an inflow in the final year of the project+s life. life. . "he costs costs associate associated d with financi financing ng are reflecte reflected d in the weighte weighted d average average cost of capital. capital. "o includ includee interest expense expense in the capital budgeting budgeting analysis would -double count the cost of debt financing. /. 0aily cash flows flows would would be be theoretica theoretically lly best, best, but they they would would be costl costly y to estimate and probably no more accurate than annual estimates because we simply cannot forecast forecast accurately at a daily level. "herefore, in most cases we simply assume that all cash flows occur at the end of the year. owever, for some projects it might be useful to assume that cash flows occur occur at midy midyear ear,, or even 3uarterl 3uarterly y or monthly monthly.. "here "here is no clear upward or downward bias on &45 since both revenues and costs are 28-1
Chat!" #$
Basics of Capital Budgeting
being recogni6ed at the end of the year. 7nless revenues and costs are distributed radically different throughout the year, there should be no bias. 8. 9n replacement projects, the benefits are generally cost savings, although the new machinery may also permit additional output. "he data for replacement analysis are generally easier to obtain than for new products, but the analysis itself is somewhat more complicated because almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. 'imilarly, differences in depreciation and any other factor that affects cash flows must also be determined. II. Problems P"o%l!& '
(a
:3uipment purchase &O%C investment 9nitial investment outlay
(4 ;,))),))) ($,))),))) (412,))),)))
(b &o, last year+s 4/),))) expenditure is considered a sun! cost and does not represent an incremental cash flow. ence, it should not be included in the analysis. (c "he potential sale of the building represents an opportunity cost of conducting the project in that building. "herefore, the possible proceeds after taxes and commissions must be charged against the project as a cost. P"o%l!& #
(a "he projected cash flow for the first year is< 4roject cash flows< t = 1 'ales revenues Operating costs 0epreciation :?9" "axes ()@ :?9" (1 A " *dd bac! depreciation 4roject cash flow = :?9" (1 A " B 0:4 28-2
41),))),))) >,))),))) 2,))),))) 4 1,))),))) )),))) 4 8)),))) 2,))),))) 4 2,8)),)))
Basics of Capital Budgeting
Chat!" #$
P"o%l!& (
:3uipment+s original cost 0epreciation (D)@ ?oo! value
42/) 2)) 4 /)
Eoss on sale = 4/ A 4/) = 4/ "ax savings = 4/ (). = 41D *ftertax salvage value = 4/ B 41D = 42$ P"o%l!& )
Eevel of wor!ing capital for old machine
= 42/,))) A 4/,))) = 42),)))
Eevel of wor!ing capital for new machine
= 42),))) A 4/,))) = 41/,)))
9ncremental investment in net wor!ing capital
= 41/,))) A 42),))) = A 4/,)))
P"o%l!& *
Eevel of wor!ing capital for old machine
= 42),))) A 4/,))) = 41/,)))
Eevel of wor!ing capital for new machine
= 4$),))) A 41),))) = 42),)))
9ncremental investment in net wor!ing capital
= 42),))) A 41/,))) = 4/,)))
28-3
Chat!" #$
Basics of Capital Budgeting
P"o%l!& +
9nvestment in net wor!ing capital
=
41,))),))) B (4>/),))) x ).) A (41,))),))) x )./)
=
4D)),)))
=
41>/,))) B 42/,))) B (4/),))) A 422,/))
=
422>,/))
=
(412),))) A 4/),))) ().88 B (4/),))) ().$
=
48$,2))
=
(4/),))) ().88 B (4/),))) A 422,/))
=
48),/))
Problems 7 through 9: P"o%l!& ,
&et investment cash flow
P"o%l!& $
Operating cash flow
P"o%l!& -
0isposal cash flow
Problems 10 through 13:
Assume that the equipment has 3-year lie or ta! purposes using straight line metho"# $ence no "epreciation can be claime" in the % th an" &th years o the pro'ect#
P"o%l!& '
&et investment in cash flow
=
41>/,))) B (41/,))) x ).8)
=
41D,)))
=
(4D),))) A 41),))) ().88 B (1>/,))) x ).$$$$ ().$
=
488,)$$
P"o%l!& ''
Operating cash flow (1 st year
28-4
Basics of Capital Budgeting
Chat!" #$
P"o%l!& '#
Operating cash flow (2 nd year
=
(4D),))) A 41),))) ().88 B (1>/,))) x .$$$$ ().$
=
488,)$$
P"o%l!& '( ("otal Cash Flows in the th year
Operating cash flow
=
(4D),))) A 41),))) ().88
=
48,2))
4roceeds for sale (no gains for loss asset fully depreciated Gecovery wor!ing capital (41/,))) x ).8) 4rojectdisposal cash flow "otal cash flow
Problems 1% through 19:
41),))) ;,))) 41;,)))
=
48,2)) B 41;,)))
=
48/,2))
Assume that the equipment has an economic lie o 3 years an" (ill be "epreciate" o)er that perio" using straight line metho"#
P"o%l!& ')
&et investment in cash flow
=
42,))),))) B (42/),))) x ).)
=
42,1)),)))
=
(4D)),))) A 4$/),))) ().88 B
P"o%l!& '*
Operating cash flow (1 st year
42,))),))) A 41,))),))) $
=
4/12,$$$
=
(4D)),))) A 4$/),))) ().88 B (421/,$$$
P"o%l!& '+
Operating cash flow (2 nd year
28-5
().$
Chat!" #$
Basics of Capital Budgeting
=
4/12,$$$
=
(4D)),))) A 4$/),))) ().88 B (421/,$$$
=
4/12,$$$
=
42,))),))) A 41,;)),)))
=
41)),))). 9f sold for 41)),))), no
P"o%l!& ',
Operating cash flow ($ rd year
P"o%l!& '$
?oo! value
gain or loss will occur. "axes
=
(41)),))) A 41)),))) ().$
=
4)
P"o%l!& '-
4rojectdisposal cash flow (end of $ rd year Gecovery of net wor!ing capital (42/),))) x .) 4roceeds from sale of e3uipment "otal
28-6
41)),))) 1)),))) 42)),)))
