lowest net present value ranked last. You would then imple- ment all those alternatives with a positive net present value if the funds were available to do so. If the funds to acquire the alternative investments were limited, you would choose that combination of projects that generates the largest total net present value with the limited funds.

# A Profitability Example

To show you how to use the net present value procedure in capital budgeting, let’s apply it to an example of deciding whether a mechanic should add a tow truck to his business. A good tow truck can be bought for $76,800. The mechanic has researched the costs to operate the truck and the possible revenues that could be earned. Additionally, he has estimated that the truck would be worth about $30,000 when the project would end in five years.

The tax rate is expected to be 35%, and the business will finance the project with 60% equity and 40% debt in the long run. The cost of equity capital (return on equity funds currently being used in the business) is 13.4%, and debt funds can be borrowed at 10.6%.

Step 1. Choose an appropriate discount rate to reflect the time value of money.

# The mechanic would compute the discount rate as:

d

= K e W e ( 1 – t ) + K d W d ( 1 – t = 0.134 x 0.6 x 0.65 + 0.106 x 0.4 x 0.65 = 0.052 + 0.028 = 0.08 )

# Where

d K_{e }

= discount rate

= cost of equity (rate of return on equity capital)

W e = p r o p o r t i o n o f e q u i t y f u n d s u s e d i the business n

K_{d }

=

d W

=

t

=

cost of debt funds (interest) proportion of debt funds in the business tax rate

6

Step 2. Calculate the present value of the cash outlay required to purchase the asset.

The purchase price of the truck is $76,800. No additional working capital will be required, and the total outlay must be committed immediately. So the present value of the cash outlay is $76,800.

Step 3. Calculate the benefits or annual net cash flow or each year from the investment over its useful li e.

The revenue from operating the truck is calculated to be $42,032 for the first year. Similarly, there are expenses associated with its operation. These are estimated to be $20,301 for year one and increase each year because of inflation.

To calculate taxes, the mechanic would subtract expenses and depreciation from the revenue to find the taxable income. These taxes will then be removed from the revenue along with the cash expenses to give annual net cash flow, which, in the first year, will be $5,590.

He would thus compute the annual net cash flows as follows for year one:

$42,032

–

20,301

+

0

–

5,590

(cash revenue) (cash expenses) (salvage value) (taxes)

= $16,141

(annual net cash flow)

$42,032

–

20,301

–

5,760

He computed income taxes for year one as:

(cash revenue) (cash expenses) (taxes)

= $15,971 (net income)

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