Question

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 company’s 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 production—number 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 peremployee—% of wages
		Cost of raw materials percan
		Other variable productioncosts per can
		Costs to purchase cans—percan
		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