Question #1
A firm believes it can generate an additional $1,700,000 peryear in revenues for the next 5 years (years 1-5) and $2,100,000for the next 5 years after that (years 6-10) if it replacesexisting equipment that is no longer usable with new equipment thatcosts $3,500,000. The existing equipment has a book value of$50,000 and a market value of $10,000. The firm expects to be ableto sell the new equipment when it is finished using it (after 10years) for $40,000. Variable costs are expected to be 44% ofrevenue for the entire 10 years. The additional sales will requirean initial investment in net working capital of $220,000, which isexpected to be recovered at the end of the project (after 10years). Assume the firm uses straight line depreciation, itsmarginal tax rate is 35%, and the discount rate for the project is11%.
a) How much value will this new equipment create for thefirm?
b) At what discount rate will this project break even?
c) Should the firm purchase the new equipment? Be sure tojustify your recommendation.
d) How would your analysis change if the firm believes theproject is more risky than initially expected? Be specific.
Question #1
A firm believes it can generate an additional $1,700,000 peryear in revenues for the next 5 years (years 1-5) and $2,100,000for the next 5 years after that (years 6-10) if it replacesexisting equipment that is no longer usable with new equipment thatcosts $3,500,000. The existing equipment has a book value of$50,000 and a market value of $10,000. The firm expects to be ableto sell the new equipment when it is finished using it (after 10years) for $40,000. Variable costs are expected to be 44% ofrevenue for the entire 10 years. The additional sales will requirean initial investment in net working capital of $220,000, which isexpected to be recovered at the end of the project (after 10years). Assume the firm uses straight line depreciation, itsmarginal tax rate is 35%, and the discount rate for the project is11%.
a) How much value will this new equipment create for thefirm?
b) At what discount rate will this project break even?
c) Should the firm purchase the new equipment? Be sure tojustify your recommendation.
d) How would your analysis change if the firm believes theproject is more risky than initially expected? Be specific.
Related questions
1)
A company is considering the purchase of a new machine for$66,000. Management predicts that the machine can produce sales of$22,000 each year for the next 10 years. Expenses are expected toinclude direct materials, direct labor, and factory overheadtotaling $10,400 per year including depreciation of $5,800 peryear. The company's tax rate is 40%. What is the payback period forthe new machine? |
3.00 years.
6.73 years.
5.17 years.
11.38 years.
17.19 years.
2)
Butler Corporation is considering the purchase of new equipmentcosting $84,000. The projected annual after-tax net income from theequipment is $3,000, after deducting $28,000 for depreciation. Therevenue is to be received at the end of each year. The machine hasa useful life of 3 years and no salvage value. Butler requires a 9%return on its investments. The present value of an annuity of 1 fordifferent periods follows: |
| Periods | 9 Percent |
| 1 | 0.9174 |
| 2 | 1.7591 |
| 3 | 2.5313 |
| 4 | 3.2397 |
| What is the net present value ofthe machine? (closest to) |
$70,876.
$78,470.
$9,000.
$84,000.
$(5,530).
3)
A company is considering a new project that will cost $19,000.This project would result in additional annual revenues of $6,000for the next 5 years. The $19,000 cost is an example of a(n):
Sunk cost.
Fixed cost.
Incremental cost.
Uncontrollable cost.
Opportunity Cost
Capital Budgeting Decision
Here is Project 2:
Hampton Company: The production department has beeninvestigating possible ways to trim total production costs. Onepossibility currently being examined is to make the cans instead ofpurchasing them. The equipment needed would cost $1,000,000, with adisposal value of $200,000, and would be able to produce 27,500,000cans over the life of the machinery. The production departmentestimates that approximately 5,500,000 cans would be needed foreach of the next 5 years.
The company would hire six new employees. These six individualswould be full-time employees working 2,000 hours per year andearning $15.00 per hour. They would also receive the same benefitsas other production employees, 15% of wages in addition to $2,000of health benefits.
It is estimated that the raw materials will cost 30¢ per can andthat other variable costs would be 10¢ per can. Because there iscurrently unused space in the factory, no additional fixed costswould be incurred if this proposal is accepted.
It is expected that cans would cost 50¢ each if purchased fromthe current supplier. The company's minimum rate of return (hurdlerate) has been determined to be 11% for all new projects, and thecurrent tax rate of 35% is anticipated to remain unchanged. Thepricing for the companyâs products as well as number of units soldwill not be affected by this decision. The unit-of-productiondepreciation method would be used if the new equipment ispurchased.
Required:
1. Based on the above information and using Excel, calculate thefollowing items for this proposed equipment purchase.
Annual cash flows over the expected life of the equipment
Payback period
Simple rate of return
Net present value
Internal rate of return
The check figure for the total annual after-tax cash flows is$271,150.
2. Would you recommend the acceptance of this proposal? Why orwhy not? Prepare a short, double-spaced paper in MS Wordelaborating on and supporting your answer.
| ACCT505 | ||||||||
| Project 2 | ||||||||
| Data: | ||||||||
| Cost of new equipment | ||||||||
| Expected life of equipment inyears | ||||||||
| Disposal value in 5 years | ||||||||
| Life productionânumber ofcans | ||||||||
| Annual production or purchaseneeds | ||||||||
| Initial training costs | ||||||||
| Number of workers needed | ||||||||
| Annual hours to be worked peremployee | ||||||||
| Earnings per hour foremployees | ||||||||
| Annual health benefits peremployee | ||||||||
| Other annual benefits peremployeeâ% of wages | ||||||||
| Cost of raw materials percan | ||||||||
| Other variable productioncosts per can | ||||||||
| Costs to purchase cansâpercan | ||||||||
| Required rate of return | ||||||||
| Tax rate | ||||||||
| Make | Purchase | |||||||
| Cost toProduce | ||||||||
| Annual cost ofdirect material: | ||||||||
| Need of 1 million cans peryear | ||||||||
| Annual cost ofdirect labor for new employees: | ||||||||
| Wages | ||||||||
| Health benefits | ||||||||
| Other benefits | ||||||||
| Total wagesand benefits | ||||||||
| Other variableproduction costs | ||||||||
| Total annualproduction costs | ||||||||
| Annual cost topurchase cans | ||||||||
| Part 1Cash Flows Over the Life of the Project | ||||||||
| Before Tax | Tax | After Tax | ||||||
| Item | Amount | Effect | Amount | |||||
| Annual cash savings | ||||||||
| Tax savings due todepreciation | ||||||||
| Total after-tax annual cashflow | ||||||||
| Part 2Payback Period | ||||||||
| Part 3Simple Rate of Return | ||||||||
| Accounting incomeas result of decreased costs | ||||||||
| Annual cash savings | ||||||||
| Less depreciation | ||||||||
| Before tax income | ||||||||
| Tax at 35% rate | ||||||||
| After tax income | ||||||||
| Part 4Net Present Value | ||||||||
| Before Tax | After Tax | 10% PV | Present | |||||
| Item | Year | Amount | Tax % | Amount | Factor | Value | ||
| Cost of machine | ||||||||
| Cost of training | ||||||||
| Annual cash savings | ||||||||
| Tax savings due todepreciation | ||||||||
| Disposal value | ||||||||
| Net Present Value | ||||||||
| Part 5Internal Rate of Return | ||||||||
| Excel function method tocalculate IRR | ||||||||
| This functionrequires that you have only one cash flow per period (Period 0through Period 5, for our example). | ||||||||
| This means that noannuity figures can be used. The chart for our example can berevised as follows. | ||||||||
| After Tax | ||||||||
| Item | Year | Amount | ||||||
| Cost of machine andtraining | 0 | |||||||
| Year 1 inflow | 1 | |||||||
| Year 2 inflow | 2 | |||||||
| Year 3 inflow | 3 | |||||||
| Year 4 inflow | 4 | |||||||
| Year 5 inflow | 5 | |||||||
