DBM 608

DBM 608
Exercise 1 – solutions
a. What is the initial net cash flow if the new machine is purchased and the old machine is replaced?
Cost of benefit – Sale Value + Tax Benefit

1,175,000 - 265,000 + 117,250 = 1,027,250
b. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation
expense if the replacement is made?
Annual depreciation allowances for both machines
 Year 1: $1,175,000 × 0.20 = $235,000

 Year 2: $1,175,000 × 0.32 = $376,000
 Year 3: $1,175,000 × 0.19 = $223,250
 Year 4: $1,175,000 × 0.12 = $141,000
 Year 5: $1,175,000 × 0.11 = $129,250
Change in the annual depreciation expense
Year New Machine Old Machine Depreciation Change in Depreciation

Depreciation
1 235,000 120,000 115,000
2 376,000 120,000 256,000
3 223,250 120,000 103,250
4 141,000 120,000 21,000
5 129,250 120,000 9,250
c. What are the incremental net cash flows in year 1 through 5?
Year After-Tax Savings Depreciation Tax Shield Incremental Net Cash Flow
1 165,750 40,250 206,000
2 165,750 89,600 255,350
3 165,750 36,137.50 201,887.50
4 165,750 7,350 173,100
5 165,750 3,237.50 168,987.50
d. Should the firm purchase the new machine? Support your answer.
Cost of Capital (WACC) of 12%. The incremental net cash flows incorporate the after-tax savings generated by the
new machine's efficiency improvements, such as reduced power usage, labor, and repair costs, as well as the tax
benefits from the increased depreciation expense.
Using these cash flows, we computed the Net Present Value (NPV) by discounting them at the 12% WACC, resulting
in a positive NPV. A positive NPV indicates that the new machine is expected to generate a return above the cost of
capital, thereby adding value to the firm. In capital budgeting terms, a project with a positive NPV should generally
be accepted, as it implies the investment will yield returns exceeding the company’s required rate of return.
Therefore, based on the financial analysis, Balboa Bottling Company should proceed with purchasing the new
machine. This decision is financially sound, as it aligns with the goal of maximizing shareholder wealth by ensuring
the project’s returns exceed the WACC, ultimately contributing to the company's overall profitability and operational
efficiency.
e. In general, how would each of the following factors affect the investment decisions, and how
should each be treated?
a. The expected life of the existing machine decreases.
- If reduced, replacing the machine sooner might be beneficial.
b. The WACC is not constant but is increasing as Balboa adds more projects into its capital budget for the year.
- Higher WACC lowers NPV, potentially making the new investment less attractive if WACC rises
significantly.
Exercise 2 – solutions
1. What is the regular payback period for these two projects?
Partial Year = Remaining Investment = 1000 – 70 = 0.6

Cash Flow in Year 3
Thus, Payback Period for Project A = 2 + 0.6 = 2.6 years
Partial Year = 1000 – 900 = 0.14

700
Thus, Payback Period for Project B = 3 + 0.14 = 3.14 years
2. If each project’s cost of capital is 12%, what is each project’s NPV?
Project A
NPV = 300 + 400 + 500 + 600 – 1000

1 2 3 4
(1+0.12) (1+0.12) (1+0.12) (1+0.12)
NPV for Project A = 323.94
Project B
NPV = 200 + 300 + 400 + 700 – 1000

1 2 3 4
(1+0.12) (1+0.12) (1+0.12) (1+0.12)
NPV for Project B = 147.30
3. What is each project’s IRR?
- IRR for Project A = 24.89%

- IRR for Project B = 17.55%
4. What is the profitability index for each project if the cost of capital is 12%?
Project A
PI = Present Value of Future Cash Flows = 1000 + 323.94 = 1.3239

Initial Investment 1000
Project B
PI = Present Value of Future Cash Flows = 1000 + 147.30 = 1.1473

Initial Investment 1000
5. Which project should be pursued under each criterion?
- Project A consistently shows stronger financial performance. Therefore, Project A is recommended as

the better investment choice for Gardial Fisheries under these capital budgeting metrics.

DBM 608 - Capital Budgeting

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Cost of benefit – Sale Value + Tax Benefit

Annual depreciation allowances for both machines

 Year 1: $1,175,000 × 0.20 = $235,000

Change in the annual depreciation expense

Year New Machine Old Machine Depreciation Change in Depreciation

c. What are the incremental net cash flows in year 1 through 5?

a. The expected life of the existing machine decreases.

- If reduced, replacing the machine sooner might be beneficial.

1. What is the regular payback period for these two projects?

Partial Year = Remaining Investment = 1000 – 70 = 0.6

Thus, Payback Period for Project A = 2 + 0.6 = 2.6 years

Partial Year = 1000 – 900 = 0.14

Thus, Payback Period for Project B = 3 + 0.14 = 3.14 years

2. If each project’s cost of capital is 12%, what is each project’s NPV?

NPV = 300 + 400 + 500 + 600 – 1000

NPV = 200 + 300 + 400 + 700 – 1000

NPV for Project B = 147.30

3. What is each project’s IRR?

- IRR for Project A = 24.89%

PI = Present Value of Future Cash Flows = 1000 + 323.94 = 1.3239

PI = Present Value of Future Cash Flows = 1000 + 147.30 = 1.1473

5. Which project should be pursued under each criterion?

- Project A consistently shows stronger financial performance. Therefore, Project A is recommended as

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