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Capital Budgeting
Capital Budgeting
Problem 1
Grimmett Company is considering purchasing a machine that would cost $403,200 and have a useful
life of 9 years. The machine would reduce cash operating costs by $74,667 per year. The machine
would have a salvage value of $60,480 at the end of the project.
Required:
a. Compute the payback period for the machine.
b. Compute the simple rate of return for the machine.
Problem 2
Corin Corporation is considering the purchase of a machine that would cost $420,000 and would last
for 8 years. At the end of 8 years, the machine would have a salvage value of $97,000. The machine
would reduce labor and other costs by $76,000 per year. The company requires a minimum pretax
return of 16% on all investment projects.
Problem 3
Ursus, Inc., is considering a project that would have a ten-year life and would require a $1,000,000
investment in equipment. At the end of ten years, the project would terminate and the equipment would
have no salvage value. The project would provide net operating income each year as follows:
All of these items, except for depreciation of $100,000 a year, represent cash flows. The depreciation
is included in the fixed expenses. The company's required rate of return is 12%.
Required:
a. Compute the project's net present value.
b. Compute the project's internal rate of return to the nearest whole percent.
c. Compute the project's payback period.
d. Compute the project's simple rate of return.
a. The payback period is computed as follows:
In this case the salvage value plays no part in the payback period since all of the investment is recovered
before the end of the project.
Simple rate of return = Annual incremental net operating income Initial investment = $36,587 $403,200 =
9.07%
a. Since depreciation is the only noncash item on the income statement, the annual net cash flow can be
computed by adding back depreciation to net operating income.
b. The formula for computing the factor of the internal rate of return (IRR) is:
Investment required Annual net cash inflow = Factor of the IRR
To the nearest whole percent, the internal rate of return is 27%.