Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 46

Capital Budgeting with Tax (non-MACRS Depreciation) and Sensitivity Analysis Gravina Company is planning to spend $6,000 for a machine that it will depreciate on a straight-line basis over 10 years with no salvage value. The machine will generate additional cash revenues of $1,200 a year. Gravina will incur no additional costs except for depreciation. Its income tax rate is 35 percent.

Required

1. What is the payback period of the proposed investment under the assumption that the cash inflows occur evenly throughout the year?

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2. What is the book rate of return (ARR) based on the initial investment outlay?

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3. What is the maximum amount that Gravina Company should invest if it desires to earn an internal rate of return (IRR) of 15 percent?

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4. What is the minimum annual (pretax) cash revenue required for the project to earn a 15 percent internal rate of return?

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5. Prepare a single schedule to show the NPVs associated with a 10-year life under annual after-tax cash flows of $500, $1,000, and $2,000 and discount rates of 10 percent, 15 percent, and 20 percent.

Step 1 of 16

Capital Budgeting is a process used to evaluate the various available projects to decide which project is to be proceeded with. First of all, we start process of capital budgeting with forecasting of future inflows and outflows of available projects. It is determined that what effect will it make on cash flows of the firm, and then NPV of project is calculated to determine how it would affect the value of firm. Net Present Value (NPV) means difference between present value of all inflows resulting from project and present value of outflows resulting from such project.