Capital Budgeting Practice Problem

Practice Problem #1: L Company is considering two new machines that should produce considerable
cost savings in its assembly operations. The cost of each machine is $14,000 and neither is expected to
have a salvage value at the end of a 4-year useful life. L Company's required rate of return is 12% and
the company prefers that a project return its initial outlay within the first half of the project's life. The
annual after-tax cash savings for each machine are provided in the following table:
Year Machine A Machine B

1 $5,000 $8,000
2 5,000 6,000
3 5,000 4,000
4 5,000 2,000
Total $20,000 $20,000
Required: a) Compute the payback period for each machine b) Compute the net present value for each
machine. c) Which machine should be purchased?
Practice Problem #2: B Company is considering purchasing equipment that costs $235,000. The
equipment has an estimated useful life of 5 years and no salvage value. B Company believes that the
annual cash inflows from using the equipment will be $65,000.
Required: a) Calculate the net present value of the equipment assuming that B Company's cost of capital
is 12%. Is the equipment an acceptable investment? b) Calculate the net present value of the equipment
assuming that B Company's cost of capital is 10%. Is the equipment an acceptable investment?
Practice Problem #3: C Company is investigating four different opportunities. Information on the four
projects under study is as follows:
Project 1 Project 2 Project 3 Project 4

Investment required $480,000 $360,000 $270,000 $450,000
Present value of cash
inflows 567,270 433,400 336,140 522,970
Net present value $87,270 $73,400 $66,140 $72,970
Life of project 6 years 12 years 6 years 3 years
The company’s required rate of return is 10%; therefore a 10% discount rate has been used in the
present value computations above. Limited funds are available for investment, so the company cannot
accept all of the available projects.
Required: a) Compute the profitability index for each investment project. b) Rank the four projects
according to preference, in terms of:  Net present value  Present value index
Practice Problem #4: S Company is considering the purchase of a new piece of equipment for laying sod.
Relevant information concerning the equipment follows:
Cost of the equipment $180,000

Annual cost savings from new equipment $37,500
Life of the new equipment 12 years
Expected Annual Net Income $15,000
Required: a) Compute the payback period for the equipment. If the company requires a payback period
of four years or less, would the equipment be purchased? b) Compute the annual rate of return on the
equipment. Would the equipment be purchased if the company’s required rate of return is 14%?
Practice Problem #5: P Company is considering a 5-year project. It plans to invest $62,000 now and it
forecasts cash flows for each year of $16,200. The company requires a minimum rate of 12%.
Required: Calculate the internal rate of return to determine whether it should accept this project.
Practice Problem #6: The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000,
$25,000, and $10,000 over four years.
Required: Using the present value index method, appraise the profitability of the proposed investment,
assuming a 10% rate of discount.
Practice Problem #7: A company is considering whether to purchase a new machine. Machines A and B
are available for $80,000 each. Earnings after taxation are as follows:
Required: Evaluate the two alternatives using the following: (a) payback method, (b) rate of return on
investment method, (c) net present value method, and (d) internal rate of return. You should use
a discount rate of 10%.
Practice Problem #8: At the beginning of 2015, a business enterprise is trying to decide between two
potential investments.
Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals under: (a)
return on investment, (b) payback period, (c) discounted payback period, and (d) profitability index.
The forecast details are given below.
Proposal A Proposal B
Cost of Investment $20,000 28,000
Life 4 years 5 years
Scrap Value Nil Nil
Net Income (After depreciation and tax)
End of 2015 $500 Nil
End of 2016 $2,000 $3,400
End of 2017 $3,500 $3,400
End of 2018 $2,500 $3,400
End of 2019 Nil $3,400
It is estimated that each of the alternative projects will require an additional working capital of $2,000,
which will be received back in full after the end of each project.
Depreciation is provided using the straight line method. The present value of $1.00 to be received at the
end of each year (at 10% p.a.) is shown below:
Year 1 2 3 4 5
P.V. 0.91 0.83 0.75 0.68 0.62

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What are the steps to evaluate investment opportunities?

What factors are considered when evaluating multiple investment opportunities with limited funds?

Practice Problem #1: L Company is considering two new machines that should produce considerable

Year Machine A Machine B

Project 1 Project 2 Project 3 Project 4

Cost of the equipment $180,000

The forecast details are given below.

P.V. 0.91 0.83 0.75 0.68 0.62

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