Capital budgeting decision on new branch The building is to

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?

Solution

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