Capital Budgeting Problem Set

Capital Budgeting Problem Set
1. Your father-in-law offers you a chance to invest in a new business which he says will
give you the following end-of-period cash flows:
CF1
CF2
CF3
CF4

$5,000
$7,000
$8,000
$10,000

Your required rate of return is 13%. What is the most you can afford to pay for this
investment assuming you believe the cash flow estimates are accurate? (PV
$21,584.39)
2. You have been offered the "privilege" of investing in a project that will return cash flows
(starting at the end of year 3) of $1,000, $2,000, $3,000 and $2,000. If your required rate
of return for this project is 12%, what is the PV of these cash flows? (PV $4,698.36)
3. Why should changes in net working capital be included in the cash flow analysis of a
project since any investments in working capital at the start-up of a project are assumed
to be returned at the termination of the project?
4. You’ve decided to build apartments on land you had been farming for years. Your spouse
says that since you already own the land you should only count the cost of building the
apartments as a relevant cost. What do you say?
5. You are adding a machine in a corner of a building you already use for production and
the firm’s accountant says you should add pro-rata share of the buildings heating bill as a
relevant cost. How would you respond?
6. Explain how to use replacement chain analysis. When would you need to use it and what
are the advantages and disadvantages?
7. Natural Fashions Inc. is looking at setting up a new manufacturing plant to produce

apparel made from hemp. The company bought some land six years ago for $700,000 in
anticipation of using it as a warehouse and distribution site, but the company decided not
to build the warehouse at that time. This seemed the right decision at the time since they
were sentenced to six years in prison for another type of “distribution” in which they
were involved. The land was appraised last week for $750,000. The company wants to
build its new manufacturing plant on this land; The plant will cost $8 million to build,
and the site requires $250,000 worth of grading before it is suitable for construction.
What is the proper cash flow amount to use as the initial investment in fixed assets when
evaluating this project? Why? ($9,000,000)


8. Assuming a discount rate of 12% and the following after-tax cash flows:
CF0
- $10,000

CF1
6,000

CF2
3,000

CF3
3,000

CF4
-2,000

CF5
-1,000

CF6
5,000

find the project’s:
NPV

______________ (578.76)

MIRR

______________

(12.89%)

Payback

______________

(2.33 yr.)

Profitability Index

______________

(1.0489)

9. Consider the following cash flows:
CFO
-$100,000

CF1
$34,000

CF2
$34,000

CF3
-$10,000

CF4
$40,000

CF5
$50,000

Assuming k=11 percent, calculate the following numbers. If any numbers might be
questionable the find another way to verify the number. Show all your work.
NPV

___________________

($6,935.68)

IRR

___________________

(13.56%)

Payback

___________________

(4.04)

MIRR

___________________

(12.4%)

PI

___________________

(1.065)

10. You are evaluating a project with the following cash flows:
CFO
-25,000

CF1
6,000

CF2
7,000

CF3
-4,000

Assume a required rate of return of 10%.
Find the NPV?
(-311.17)
Find the Payback ? (4.1 yr.)
Should you calculate the project’s IRR? Why or why not?
Find the MIRR? (9.75%)

CF4
15,000

CF5
10,000


11. A project has the following cash flows: (assume a required rate of return of 10%)
CF0
-$100,000

CF1
$40,000

CF2
$40,000

CF3
$60,000

CF4
-$20,000

CF5
$10,000

Can you use IRR to determine if this is an attractive project? Why or why not?
Calculate the MIRR for this project.
12. What are the problems associated with exclusively using IRR to choose investment
projects?
13. Why can’t you use IRR to choose between mutually exclusive projects?
14. Explain the advantages that MIRR has over IRR
15. What are the disadvantages of using regular payback?
16. What is the one advantage that IRR has over NPV?
17. In outline form, explain the problems associated with using IRR both with independent
and mutually exclusive projects. Make sure you identify the source of the problems if
relevant.
Even after you share the above information with your boss why might she still want you
to use IRR in all your presentations to the Board of Directors?
18. The Malone Truck Company is considering opening a new loading dock at a cost of
$280,000 for new equipment and will require an investment of $20,000 in accounts
receivable. The life of the new equipment is seven years. The equipment will be
depreciated straight-line over its seven-year life to a salvage value of zero, even though it
is expected that the equipment to have revenues of $250,000 per year over the next seven
years, but revenues from the firm’s other loading docks is expected to decrease by a total
of $25,000 per year because some of their business will move to the new loading dock.
Fixed costs for the new dock are estimated to be $26,000 per year and variable costs are
expected to be $155,000 per year. The firms tax rate is 34% and the required rate of
return is 15%. What should the firm do? (NPV -112,599.78; IRR 1.93%)
19. Dagny Corporation is evaluating whether to replace a printing press with a newer model,
which, owing to more efficient operation, will reduce operating costs from $40,000 to
$32,000 per year. Sales are not expected to change. The old press cost $60,000 when
purchased five years ago, had an estimated useful life of 15 years, zero salvage value at

the end of its useful life and is being depreciated straight-line. At present, its market
value is estimated to be $40,000, if sold outright. The new press costs $80,000 and would
be depreciated straight-line to a zero salvage over a ten-year life. However, management
expects to be able to sell the new press for $15,000 at the end of ten years. The


corporation has a 40% marginal tax rate and a cost of capital of 15%. What should
management do? (NPV –5,655.22; IRR 11.47%)
20. John Burke, Inc. is considering leasing a machine for eight years at an annual rental of
$34,000, which includes all maintenance. The alternative is to purchase the machine for
$190,000 and have maintenance expenses of $15,000 per year. However, if you purchase
the machine you get to depreciate it straight-line over the eight year period. Assume a
zero salvage value at the end of eight years and a 40% tax rate. The firm’s required rate
of return is 12%. Should the firm buy or lease? You will have to use your cash flow sheet
in order to determine the annual cost of purchasing the machine. (NPV –187,516.18;
EAC $37,747.54)
21. You are evaluating two different sound mixers. The JazzMaster costs $45,000 and has a
three-year life, and costs $5,000 per year to operate. The DiscoMaster costs $65,000, has
a five-year life and costs $4,000 per year to operate. The relevant discount rate is 12%.
Ignoring depreciation and taxes, compute the equivalent annual cost for both. Which do
you prefer? (EAC of JazzMaster 23,735.71; EAC of DiscoMaster 22,031.63)
22. What error(s) might be introduced by using nominal cash flows and discount rates to
calculate equivalent annual costs?
23. After the long drought of 1992, the manager of Long Branch Farm is considering the
installation of an irrigation system. The system has an invoice price of $100,000 and will
cost an additional $15,000 to install. It is estimated that it will increase revenues by
$20,000 annually, although operating expenses other than depreciation will also increase
by $5,000. The system will be depreciated straight-line over its depreciable life (5 years)
to a zero salvage value. The system can actually be sold for an estimated $25,000 at the
end of 5 years. If the tax rate on ordinary income is 40 percent and the firm’s required

rate of return is 16 percent, should the firm purchase the system? Why? Show your
work. (NPV –48,266.16; IRR –2.43%)
24. If Long Branch farms had spent $5,000 over the previous year doing studies of longrange weather patterns in order to determine if they could use an irrigation system
effectively, how should that cost be taken into account in today’s analysis of this
particular irrigation system?
25. Top-Sider is considering the purchase of a new leather-cutting machine to replace an
existing machine that has a book value of $3,000 and can be sold today for $1,500. The
old machine is being depreciated on a straight-line basis and its estimated salvage value
in 3 years is zero. The new machine will reduce costs (before taxes) by $7,000 per year.
The new machine has a 3-year life, it costs $14,000, and it can be sold for an expected
$2,000 at the end of the third year. If the new machine is purchased it will require the
firm to maintain an additional $500 in spare parts inventory. The new machine would be
depreciated straight-line over its 3-year life. Assuming a 40 percent tax rate and a
required rate of return of 13 percent, what should the firm do? Show your work.


(NPV $2,158.84; IRR 22.55%; MIRR 19.21% CF0 = -12,400 CF1-3 = 5667 CFT =
1700)
26. What is the difference between IRR and MIRR? Is MIRR an improvement over IRR? If
so, why? Calculate the MIRR of at least one of the projects on this exam and show your
work here.
27. You are considering two different vacuums to use in your new hotel. The Hoover Pro-5
would cost $675 each and would have maintenance and supply costs of $125 per year
over its 4-year life. The new Porsche Turbo-Magnum model would cost $900 and would
not require bags since it uses a new bag-less dirt chamber. It would have maintenance
expense of $90 per year over its 6-year life. Your required rate of return would be 9%
and you are in a 40% tax rate. Either vacuum would be depreciated straight-line over its
useful life. Which should you choose? Show your work. (Hoover NPV –699.30 and
EAA -215.85; Porsche NPV -873.08, EAA -194.63)
28. Two projects have the following cash flows:

Project A:
Project B

-10,000
-8,000

4,000
3,200

3,000
2,800

6,000
4,500

Find the IRR and NPV of both projects. Assume a 10% required rate of return. Is there a
conflict? Which project should you choose?
29. IBC Industries recently purchased three new injection molding machines and spent
$100,000 having their entire work force trained to use the new machines. The machines
have worked very well and cut defects by 30%, so IBC is running CF figures in order to
determine if they should replace three more of the old style machines with the new
machines. Is the $10,000 training cost spent when the first machines were bought a
relevant CF for the purchase of the second group of machines? Why or why not?
30. A Brazilian bank needs to purchase a new computer system for its New York office. The
bank can either lease a new system for five years for $100,000 per year or they can
purchase their own system which will cost $450,000 and have operating costs of $20,000
per year. The required rate of return for the bank is 10%. Find the EAC of purchasing the
new computer system in order to determine if the bank should lease or buy the system.
Assume that either system would be essentially worthless at the end of the five year
period. (138,708.87 Ignore D+T)

31. Matrix Printers, Inc. is considering entering the laser printing business. An entirely new
plant will be needed which will cost $1,500,000. Land for the plant will cost an
additional $250,000. Both of these costs will be incurred immediately. The plant will be
depreciated straight line over its 15 year life. (Remember the rule about depreciating
land.) In addition to these costs an investment of $100,000 will be needed for working
capital. The plant will generate sales of $300,000 per year and have associated expenses
of $175,000. The firms marginal tax rate is 34%. The plant will be sold in 15 years for


$700,000 ($200,000 for the land and $500,000 for the plant). What is the NPV of making
this investment if the required rate of return is 16%. Should they make the investment?
(NPV = -$1,130,630)
32. Matrix Printers, Inc. discovered a totally new method of laser printing and insiders have
stated that this the most revolutionary breakthrough ever made by the firm. Matrix
estimates that to put the new printers into the production the firm will have to invest
$1,000,000 and that the firm will be able to have positive cash flows of $500,000 per year
for the next four years until the competition catches up. Matrix required rate of return is
12%. What is the IRR on this new project? Is this a realistic estimate of Matrix actual
earnings over the four year period? Can you help them make a better estimate of the
firm's actual IRR over the period? What is that more realistic rate and why is it better?
(IRR 34.90%; MIRR 24.33%)
33. What is it that makes MIRR superior to IRR? Be precise and thorough.
34. List three potential problems with using IRR in making capital budgeting decisions.
35. Given the advantages of NPV over all other capital budgeting tools why would you ever
want to compute payback, IRR, MIRR or PI?
36. Would there ever be situations where a firm would knowingly accept projects with a
negative NPV? If so, what might these be?
37. Describe how an investment opportunity schedule and an MCC schedule can be used
together to determine the optimal capital budget. What would you do if a break point in
the MCC schedule came in the middle of one of the projects on the investment

opportunity schedule. you may use a simple example to illustrate , if you like.
38. Capitol City transfer Company is considering building a new terminal in Salt Lake City.
If the company goes ahead with the project, it will spend $1 million immediately and
another $1 million at the end of year 1. It will then receive net cash flows of $500,000 at
the end of years 2-5, and it expects to sell the property for $1 million at the end of year 6.
The company's cost of capital is 12 percent, and it used the MIRR criterion for capital
budgeting decisions. What is the project's MIRR? (MIRR 11.7%)
39. Mary was thinking about buying some little lambs and raising the to sell. the lambs cost
$5,000 (lamb prices are now abnormally low and may never be this low again) and Mary
thought hat she could sell several lambs each year and thus receive $3,500 per year for
the next three years. Mary, being the sophisticated investor that she was, calculated the
IRR on this investment and found it to be almost 49%. Mary thought that this seemed
very high, given that she normally earned about 15% on lamb investments. If Mary’s
returns are usually in the 15% range and will probably be about that in the further, can
you help Mary to make a more realistic estimate of the actual rate of return that she can
earn on her lamb investment over the next three years? Show and explain all of your
work. (MIRR 34.46%)


40. What is the NPV of the following set of cash flows if the required rate of return is 18%?
Year
0
1
2
3
4

Cash Flow
-$50,000
– 5,000

50,000
50,000
–5,000

Would you want to calculate IRR on this investment? Why or why not?
41. Ball Corporation is currently evaluating two mutually exclusive projects which have the
following net cash flows:
0
1
2
3
4
5
6

A
-$5,000
3,000
3,000
3,000

B
-$10,000
3,500
3,500
3,500
3,500
3,500
3,500

Both projects have a cost of capital of 10 percent. Totally new equipment must be
procured in 6 years, but Project A would be replicated if it were chosen. Which project
should Ball select, and why?
42. The Harris Company has a choice between two mutually exclusive projects, S, which has
a cost of $200,000 and will provide cash flows of $100,000 per year at the end of each of
the next three years, or L, which costs $425,000 and will provide cash flows of $200,000
per year for three years. Harris’s cost of capital is 10 percent.
Find the NPV and IRR of each project
What factors could possibly be causing the conflict between NPV and IRR?
Which one should be chosen?
43. Obviously, if a project has a positive NPV it will have a PI greater than 1.0. Should you
automatically choose projects with the highest PI if you are choosing between mutually
exclusive projects?
44. What problems would it cause if a corporation used the same required rate of return for
each project it considered in every division? How do corporations handle this problem in
practice?


45. Although NPV and IRR give the same accept/reject decision they can often conflict when
choosing between mutually exclusive projects. Why?
46. International Soup Company is considering replacing a canning machine. The old
machine is being depreciated by the straight-line method over a 10-year recovery period
from a depreciable cost basis of $120,000. The old machine has 5 years of remaining
usable live, at which time its salvage value is expected to be zero, and it can be sold now
for $40,000. This machine has a current book value of $60,000.
The purchase price of the new machine is $250,000 and it will have shipping and
installation costs of $12,500. It has a 5-year life and an expected salvage value of
$25,000. Annual savings of electricity, labor and materials from use of the new machine
are estimated at $40,000. The new machine will require an additional inventory of spare
parts of $30,000. The company is in a 40 percent tax bracket, and its cost of capital is 16

percent. The machine will be depreciated straight line over its five-year life. What
should the firm do? Show your work. ( NPV –91,448.31; IRR 0.18%; Payback 4.98)
47. You have become very successful and are considering the purchase of a plane for your
firm. The Piper model has an initial cost of $375,000, annual operating costs of $24,000
and a salvage value of $150,000. Its estimated holding period is 7 years. The Cessna
model has an initial cost of $325,000, but annual operating costs of $29,500 and an
estimated salvage value of $100,000. Its estimated holding period is 8 years. Your cost
of capital is fifteen percent. Ignoring depreciation and taxes, which model would be the
best choice assuming they both would perform the required tasks?
48. We project unit sales for a new household-use laser-guided cockroach search and destroy
system (a joint venture of Lockheed and Aerojet) as follows:
Year
Year
Year
Year
Year

1
2
3
4
5

53,000 units
65,000 units
76,000 units
86,000 units
86,000 units

The new system will be priced to sell at $95 each. The cockroach eradicator project will

require $585,000 in new working capital. The variable cost per unit is $60, and total fixed
costs are $25,000 per year. The equipment necessary to begin production will cost a total
of $6,500,000. This equipment can be depreciated straight-line over its useful life of five
years. In five years it will actually be worth about 30 percent of its cost. The relevant tax
rate is 34%, and required return is 20%. Based on these preliminary estimates, what is the
NPV of the project? (NPV -$224,835.20)
49. The Shadrach Corporation is thinking about replacing one of its large furnaces with a
newer, more efficient model. The new model would cost $150,000, but would save
$35,000 per year in fuel costs. The new model could be depreciated straight-line over its
five year life to a salvage value of zero. The furnace could actually be sold for $45,000 at


that time. The old furnace cost $100,000 two years ago, could currently be sold for
$60,000, and was being depreciated straight-line over its 7 year life. The old furnace was
not expected to have any value at the end of its useful life in 5 years. Assuming a tax rate
of 34% and a 12% required rate of return, should you replace the old furnace? (NPV
33,268.43)
50. Rick Bardles and Ed James are considering building a new bottling plant to meet
expected future demand for their new line of tropical coolers. They are considering
putting it on a plot of land they have owned for three years. They are in the process of
analyzing the idea and comparing it to some others. Bardles says, “Ed, when we do this
analysis, we should put in an amount for the cost of the land equal to what we paid for it.
After all it did cost us a pretty penny.” James retorts, “No, I don’t care how much it costwe have already paid for it. It is what they call a sunk cost. The cost of the land shouldn’t
be considered.” What would you say to Bardles and James?
51. Meals on Wings, Inc. supplies prepared meals for corporate aircraft (a opposed to
airlines) and it needs to purchase new broilers. If the broilers are purchased, they will
replace old broilers purchased 10 years ago for $105,000 and which are being depreciated
on a straight-line basis to a zero salvage value (15-yeardepreciable life). The old broilers
can be sold for $60,000 the new broilers will cost $200,000 installed and will be
depreciated straight -line over their 5-year class life to a salvage value of zero, although

they are expected to have a salvage value of $12,000 in five years. The firm expects to
increase its revenues by $18,000 per year if the new broilers are purchased, but cash
expenses will also increases by $2,500 per year. If the firm's cost of capital is 10 percent
and its tax rate is 34 percent, what is the NPV of the broilers? (NPV -62,269.93)
52. You have been asked by the president of your company to evaluate the proposed
acquisition of a new special-purpose truck. The truck’s basic price is $50,000 and it will
cost another $10,000 to modify it for special use by your firm. The truck falls into a fiveyear depreciation class and will be depreciated to zero over the five-year period. The
truck is actually expected to be sold for $20,000 after three years when the project is
ended. Use of the truck will require an increase in net working capital of $2,000 (spare
parts). The truck will have no effect on revenue, but it is expected to save the firm
$22,000 per year in before-tax operating costs, mainly labor. The firms marginal tax rate
is 40 percent and the required rate of return on the project is 13 percent. What should you
do?(NPV -$3143.27; IRR 10.39%)
53. You have been asked by the president of your firm to evaluate the proposed acquisition
of spectrometer for the firm’s R&D department. The equipment’s base price is $140,000
and it would cost another $30,000 to modify it for special use by your firm. The
spectrometer (plus the modification) would be depreciated straight-line over its five-year
life to a salvage value of zero, but it is expected that the instrument would be sold after 3
years for $60,000. Use of the equipment would require an increase in net working capital
(spare parts inventory) of $8,000. The spectrometer would have no effect on revenues,
but it is expected to save the firm $50,000 per year in before-tax operating costs, mainly


labor. The firm’s marginal tax rate is 34%. If the firm’s cost of capital is 12%, should the
equipment be purchased?(NPV= -20,637.30 IRR= 6.13%)
54. The Erley Equipment Company purchased a machine 5 years ago at a cost of $100,000.
the machine had an expected life of 10 years at the time of purchase, and an expected
salvage value of zero at the end of 10 years. It is being depreciated by the straight-line
method over its 10-year life.
A new machine can be purchased for $150,000, including installation costs. During its 5year life, it will reduce cash operating expenses by $50,000 per year. Sales are not

expected to change. At the end of its useful life, the machine is estimated to be worthless.
The machine would be depreciated straight-line over 5 years.
The old machine can be sold for $65,000. The firm’s tax rate is 34%. the appropriate
discount rate is 16%. Should the replacement machine be purchased? Show your work.
(NPV at 16% 40,216.89; IRR 33.92%)
55. The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a
new computer. The computer’s price is $40,000 and it would cost $5,000 to install the
system. The system falls into the 3-year depreciation class (straight-line to zero book
value). Purchase of the computer would require an increase in net working capital of
$2000. The computer would increase the firm’s revenues by $20,000 per year, but would
also increase the firm’s operating costs by $5,000 per year. The computer is expected to
be used for 3 years and then be sold for $25,000. The firm’s marginal tax rate is 40
percent, and the project’s cost of capital is 14 percent. What should the firm do? Show
your work. (NPV –701.00)
56. Blue Note Jazz Productions has decided to cash in on the country craze by starting a
subsidiary that will promote concerts by "Country Jazz" artists for the next three years.
The country music boom is expected to subside by this time and the subsidiary will be
folded. Blue Note expects that average ticket prices will be $35 and that ticket sales for
the three years will be 300,000 per year. Fixed cost each year are expected to be
$3,000,000 and variable costs are expected to be 25% of sales. The subsidiary will need
$4,000,000 in new equipment to start up and requires a $300,000 investment in working
capital. The $4,000,000 in equipment will be depreciated straight-line over five years to a
zero salvage value, but will be sold at the end of three years for an estimated $1,500,000.
What is the NPV of this new investment if the firm's required rate of return is 12%? The
firm's marginal tax rate is 40%. What is the IRR? Should the project be accepted? (IRR
37.20%; NPV $2,276,314.23; MIRR 29.04%)
57. Mom’s Cookies, Inc. is considering the purchase of a new cookie oven. The original cost
of the old oven was $30,000; it is now 5 years old, and it has a current market value of
$5,000. The old oven is being depreciated over a 10-year life towards a zero estimated
salvage value on a straight line basis, resulting in a current book value of $15,000 and an

annual depreciation expense of $3,000. Management is contemplating the purchase of a
new oven whose cost is $25,000 and whose estimated salvage value is zero. Expected


cash savings from the new oven are $20,000 a year (before tax). Depreciation is
computed using 5-year straight-line depreciation and the cost of capital is 10 percent.
Assume a 40 percent tax rate. What is the NPV of the new oven? (NPV $32,522.07;
IRR 75.15%)
58. Mc Laughlin Mills is evaluating the proposed acquisition of a new milling machine. The
machine’s base price is $180,000 and it would cost another $25,000 to modify it for
special use by your firm. The machine would be depreciated straight-line over 5 years
and it would be sold after three years for $80,000. The machine would require an increase
in net working capital (inventory) of $7,500. The machine would have no effect on
revenues, but it is expected to save the firm $75,000 per year in before-tax operating
costs, mainly labor. McLaughlin’s marginal tax rate is 34% and the appropriate discount
rate is 10%. What should they do? (NPV 11,516.83)
59. The Wingler Equipment Company purchased a machine 5 years ago at a cost of
$100,000. It had an expected life of 10 years at the time of purchase and an expected
salvage value of zero at the end of the 10 years. It is being depreciated by the straight line
method toward a salvage value of zero.
A new machine can be purchased for $150,000, including installation costs. Over its 5year life, it will reduce cash operating expenses by $50,000 per year. Sales are not
expected to change. At the end of its useful life, the machine is expected to be sold for
$40,000. The machine would be fully depreciated straight-line over 5 years (30,000 per
year).
The old machine can be sold today for $65,000. The firm’s tax rate is 34%. The
appropriate discount rate is 15%. What should they do? (NPV 56,441.24)
60. The Wingler Equipment company purchased a machine two years ago at a cost of
$77,000. It had an expected life of seven years at the time of purchase and was being
depreciated straight-line over its expected life to a salvage value of zero. This machine
could be sold today for $45,000

A new machine with breakthrough technology can be purchased for $140,000 and it
would cost $10,000 to install. Over its five-year expected life it will reduce cash
operating expenses by $50,000 per year. Sales are not expected to change. At the end of
its useful life the machine is estimated to be worth $20,000. The machine, if purchased,
will be depreciated straight line over its expected life down to a salvage value to zero.
What should you do if your required rate of return is sixteen percent? (NPV $32,878.07;
IRR 28.68%)
61. Southwest Airlines is considering the purchase of a new baggage-handling machine that
moves bags quicker and with less damage. The cost is $160,000. The machine will be
depreciated using the straight line method over its seven year life. If the machine is
purchased, SWA will save $31,000 per year in damaged bags costs during the first five
years. Because of higher maintenance costs during the last two years the savings will


only be $28,000. the firm is in a34% tax bracket. Given that the firm’s required rate of
return is 13%, compute the NPV and IRR of the investment. Should they make the
investment? (NPV –36,936.03; IRR 5.08%)
62. Mills Corp. is considering adopting one of two machines. Machine A requires an up-front
expenditure of $450,000, has an expected life of two years, and will generate positive
AFTER-TAX cash flows of $350,000 per year. Machine B requires an expenditure of
$1,000,000 and has an expected life of three years and will generate AFTER-TAX cash
flows of $450,000 per year. The cost of capital is 10%. What is the EAA of the better
machine? (EAA of A 90,714.29; EAA of B 47,885.20)
63. Filkins Fabric Company is considering the replacement of its old, fully depreciated
knitting machine. Two new models are available: Machine 190-3 which has a cost of
$190,000, a three-year expected life, and after-tax cash flows (labor savings and
depreciation) of $87,000 per year; and Machine 360-6 which has a cost of $360,000, a
six-year life, and after-tax cash flows of $98,300 per year. Assume that Filkins’ cost of
capital is 14%. Which machine should they buy assuming they expect to be in business at
least 6 years.

(NPV of M3 $11,981.99, EAA 5,161.06; NPV of M6 $22,256.02, EAA 5,723.30)
What implicit assumption is built into this analysis?
64. Sony Corporation is considering the purchase of a new phone system for a sales office in
Boise, Idaho. The Lucent Technologies system costs $54,000, has annual operating
expenses of $4,000 and an expected life of 9 years. The Toshiba system has a cost of
$48,000, annual operating expenses of $4,000 and an expected life of 7 years. Ignoring
depreciation and taxes and assuming a cost of capital of 9 percent for such an investment,
which system should Sony purchase? You are free to use either replacement chain or
EAA/EAC analysis.
( Lucent EAA -13,007.14, NPV-77,980.99; Toshiba EAA -13,537.14, NPV -68,131.81)
65. You are evaluating two different silicon wafer milling machines. the Techron I cost
$150,000, has three-year life, and has pre-tax operating cost of $30,000 per year. the
Techron II costs $250,000, has a five-year life, and has pre-tax operating costs of $17,000
per year. For both milling machines, use straight-line depreciation to zero over the
project’s life and assume a salvage value of $20,000. If your tax rate is 35 percent and
your discount rate is 18 percent, compute the EAC for both machines. Which do you
prefer? Why? (NPV of I is –146,436.34 ad EAC –67,349.57; NPV of II-224,147.33 and
EAC 71,677.35)
66. A small real estate office needs a new copier. They have their choice between
leasing a new copier for $2,000 per year with all maintenance included or they can
purchase their own copier for $4,200 and would incur $1,200 per year in operating costs.
Paper and cartridge costs for the copier would be identical in either case. The lease would
be for a total of 6 years and the copier, if bought, would have a useful life of 6 years and
no expected salvage value at the end of that time. Determine if owning the machine


would be cheaper on a per-year basis than leasing the machine. Then firm’s tax rate is
34% and the proper required rate of return for the project would be 7%. (Annual after-tax
cost of lease is $1,320 per year. NPV for purchase of copier is -$6840.66 giving an EAC
of $1,435.14 per year. Take the one with the lowest annual cost – the lease.)