Question

What are the variety of capital budgeting tools including net present value (NPV), internal rate of return (IRR), payback period, and profitability index (PI). Only evaluate the incremental changes to cash flows.

Use an Excel spreadsheet showing the required cash flow forecasts and capital budgeting tool calculations.

Major Equipment Purchase

• A new major equipment purchase, which will cost $10 million; however, it is projected to reduce cost of sales by 5% per year for 8 years.
• The equipment is projected to be sold for salvage value estimated to be $500,000 at the end of year 8.
• Being a relatively safe investment, the required rate of return of the project is 8%.
• The equipment will be depreciated at a MACRS 7-year schedule.
• Annual sales for year 1 are projected at $20 million and should stay the same per year for 8 years.
• Before this project, cost of sales has been 60%.
• The marginal corporate tax rate is presumed to be 25%.

Answer 1

Cost savings = 5%*60%*Sales

Tax shield = Depreciation*Tax rate

The incremental and cumulative cash flows are

Year	Initial cost	Cost saving after tax	Tax shield on depreciation	Salvage after tax	NetCF	Cumulative CF
0	-10000000				-10000000	-10000000.00
1		450000	357250		807250	-9192750.00
2		450000	612250		1062250	-8130500.00
3		450000	437250		887250	-7243250.00
4		450000	312250		762250	-6481000.00
5		450000	223250		673250	-5807750.00
6		450000	223000		673000	-5134750.00
7		450000	223250		673250	-4461500.00
8		450000	111500	375000	936500	-3525000.00

NPV	-5296130.46
IRR	-8.97%
Payback	More than 8 years
PI	0.47

WORKINGS