Chapter 12: The Capital Budgeting Decision
12-41
29. MACRS depreciation and net present value (LO4) Universal Electronics is considering the
purchase of manufacturing equipment with a 10–year midpoint in its asset depreciation range
(ADR). Carefully refer to Table 12–8 to determine in what depreciation category the asset falls.
(Hint: It is not 10 years.) The asset will cost $90,000, and it will produce earnings before
depreciation and taxes of $32,000 per year for three years, and then $12,000 a year for seven
more years. The firm has a tax rate of 34 percent. With a cost of capital of 11 percent, should it
purchase the asset? Use the net present value method. In doing your analysis, if you have years
in which there is no depreciation, merely enter a zero for depreciation.
12–29. Solution:
Universal Electronics
Because the manufacturing equipment has a 10-year midpoint
of its asset depreciation range (ADR), it falls into the seven–
year MACRS category as indicated in Table 12–8.
We first determine the annual depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $90,000 .143 $12,870
2 90,000 .245 22,050
Chapter 12: The Capital Budgeting Decision
12-42
12-29. (Continued)
Annual Cash Flow
1
2
3
4
5
6
7
8
9
10
EBDT
$32,000
$32,000
$32,000
$12,000
$12,000
$12,000
$12,000
$12,000
$12,000
$12,000
– D
12,870
22,050
15,750
11,250
8,010
8,010
8,010
4,050
0
0
EBT
$19,130
$ 9,950
$16,250
$ 750
$ 3,990
$ 3,990
$ 3,990
$ 7,950
$12,000
$12,000
T (34%)
6,504
3,383
5,525
255
1,357
1,375
1,375
2,703
4,080
4,080
EAT
$12,626
$ 6,567
$10,725
$ 495
$ 2,633
$ 2,633
$ 2,633
$ 5,247
$ 7,920
$ 7,920
+ D
12,870
22,050
15,750
11,250
8,010
8,010
8,010
4,050
0
0
Cash Flow
$25,496
$28,617
$26,475
$11,745
$10,643
$10,643
$10,643
$ 9,297
$ 7,920
$ 7,920
Chapter 12: The Capital Budgeting Decision
12-43
12-29. (Continued)
Next determine the net present value.
Cash Flow Present
Year (inflows) PVIF at 11% Value
1 $25,496 .901 $ 22,972
2 28,617 .812 23,237
3 26,475 .731 19,353
Chapter 12: The Capital Budgeting Decision
12-44
30. Working capital requirements in capital budgeting (LO4) The Bagwell Company has a
proposed contract with the First Military Base Facility of Texas. The initial investment in land
and equipment will be $90,000. Of this amount, $60,000 is subject to five–year MACRS
depreciation. The balance is in nondepreciable property (land). The contract covers six year
period. At the end of six years the nondepreciable assets will be sold for $30,000. The
depreciated assets will have zero resale value.
The contract will require an additional investment of $40,000 in working capital at the
beginning of the first year and, of this amount, $20,000 will be returned to the Bagwell
Company after six years.
The investment will produce $32,000 in income before depreciation and taxes for each of
the six years. The corporation is in a 35 percent tax bracket and has a 10 percent cost of capital.
Should the investment be undertaken? Use the net present value method.
12–30. Solution:
Bagwell Ball Bearing Company
Although there are some complicating features in the problem,
we are still comparing the present value of cash flows to the
total initial investment.
The initial investment is:
Non Depreciable Land …… $ 30,000
Chapter 12: The Capital Budgeting Decision
12-45
12-30. (Continued)
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $60,000 .200 $12,000
2 60,000 .320 19,200
We then determine the annual cash flow. In addition to normal
cash flow from operations; we also consider the funds
Annual Cash Flow
1 2 3 4 5 6
EBDT $32,000 $32,000 $32,000 $32,000 $32,000 $32,000
– D 12,000 19,200 11,520 6,900 6,900 3,480
Chapter 12: The Capital Budgeting Decision
12-46
12-30. (Continued)
We then determine the net present value.
Cash Flow Present
Year (inflows) PVIF at 10% Value
1 $ 25,000 .909 $ 22,725
2 27,520 .826 22,732
3 24,832 .751 18,649
31. Tax losses and gains in capital budgeting (LO2) An asset was purchased three years ago
for $120,000. It falls into the five-year category for MACRS depreciation. The firm is in a
35 percent tax bracket. Compute the following:
a. Tax loss on the sale and the related tax benefit if the asset is sold now for $12,560.
b. Gain and related tax on the sale if the asset is sold now for $51,060. (Refer to footnote 4 in
the chapter.)
12–31. Solution:
First determine the book value of the asset.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $120,000 .200 $24,000
Chapter 12: The Capital Budgeting Decision
12-47
Purchase price $120,000
– Total depreciation to date 85,440
Book value $ 34,560
a. $12,560 sales price
b. $51,060 sales price
Sales price $51,060
32. Capital budgeting with cost of capital computation (LO5) DataPoint Engineering is considering
the purchase of a new piece of equipment for $220,000. It has an eight-year midpoint of its asset
depreciation range (ADR). It will require an additional initial investment of $120,000 in
nondepreciable working capital. Thirty thousand dollars of this investment will be recovered after
the sixth year and will provide additional cash flow for that year. Income before depreciation and
taxes for the next six years will be:
Year Amount
1 ……………….. $170,000
2 ……………….. 150,000
3 ……………….. 120,000
4 ……………….. 105,000
5 ……………….. 90,000
6 ……………….. 80,000
Chapter 12: The Capital Budgeting Decision
12-48
The tax rate is 30 percent. The cost of capital must be computed based on
the following (round the final value to the nearest whole number):
Cost (aftertax)
Weights
Debt ………………………………………………….
Kd
6.5%
30%
Preferred stock ……………………………………
Kp
10.2
10
Common equity (retained earnings). ………
Ke
15.0
60
a. Determine the annual depreciation schedule.
b. Determine annual cash flow. Include recovered working capital in the sixth year.
c. Determine the weighted average cost of capital.
d. Determine the net present value. Should DataPoint purchase the new equipment?
12–32. Solution:
DataPoint Engineering
a. An 8-year midpoint of the ADR leads to 5–year MACRS
depreciation.
Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $ 220,000 .200 $ 44,000
2 220,000 .320 70,400
Chapter 12: The Capital Budgeting Decision
12-49
b. Annual Cash Flow
1
2
3
4
5
6
EBDT
$170,000
$150,000
$120,000
$105,000
$90,000
$80,000
– D
44,000
70,400
42,240
25,300
25,300
12,760
EBT
$126,000
$ 79,600
$ 77,760
79,700
$64,700
67,240
T (30%)
37,800
23,880
23,328
23,910
19,410
20,172
EAT
88,000
55,720
54,432
55,790
45,290
47,068
+ D
44,000
70,400
42,240
25,300
25,300
12,760
+ Recov-
ery of
working
capital
30,000
Cash
Flow
$132,200
$126,120
$ 96,672
$ 81,090
$70,590
$89,828
12-31. (Continued)
c. Weighted Average Cost of Capital
Cost
(after tax)
Weights
Weighted
Debt
kd
6.5%
30%
1.95%
Preferred stock
kp
10.2%
10%
1.02%
Common equity
(retained earnings)
ke
15.0%
60%
9.00%
Weighted average
cost of Capital
11.97%