Capital budgeting decision on new branch The building is to be constructed on la
ID: 2770158 • Letter: C
Question
Capital budgeting decision on new branch
The building is to be constructed on land leased for $21,000 per year Net working capital must be increased by $100,000 Annual revenues from the new branch will be $400,000 Of this $400,000 in revenues, $55,000 will be drawn away from the bank’s main office The new branch will incur about $130,000 per year in other expenses Both expenses and revenues are expected to remain approximately constant over the branch’s 20-year life Marginal tax rate is 40% Cost of capital 9%
Answer the following questions: What is the cash flow for the branch’s 20-year life Calculate the NPV, Profitability index, and Internal rate of return (IRR).
Should the project be accepted?
Explanation / Answer
Cost of Building is not given in the problem, so it is assumed at $1,000,000;
Step 1:
Cost of Building $ 1,000,000
Increae in Net workng capitla 100,000
Total cost 1,100,000
Step 2: Net cash inflows:
Cash folws per annum for 1 to 19 years 142,400
Return of working capital 100,000
Total cash flow for 20th year 242,400
CALCULATION OF NPV, PROFITABILIT INDEX AND IRR:
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Cash inflows for 1 to 19 years per annum $142,400
Annuity factor at 9% for 19 years(from annuity table) 8.9501
Total discounted cash flows (142,400 x 8.9501) 1,274,494
Cash inflow for 20th year $242,400
Present value factor @9% for 20th year (from annuity table) 0.1784
Discounted cash flows for 20th year ( 242,400 x 0.1794) 43,487
Total Discouted cash flows 1,317,981
Less: Initial investmetn : 1,100,000
Net present Value (NPV) 217,981
Profitability Index (Total Discounted cash inflow/Initial investment) (ie. 1,317,981/1,100,000) = 1.20
CALCULATION OF IRR:
Internal rate of return is that rate at which the present value of cash inflows and outflows must be equal, so we try NPV @ 15% 6.1982
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Annual cash flows for 1 to 19 years $142,400
Annuity factor @15% for 19 yeas 6.1982
Discounted cash flows (142,400 x 6.1982) 882,624
Cash flow for 20th year 242,400
Present value factor @15% for 20th year 0.0611
Discounted cash flows (242,400 x 0.0611) 14,811
Total discounted cash flows for 1 to 20 years 897,435
Less: Initial investment 1,100,000
NPV (-) 202,565
By interpolation IRR is as follows