MV e-orrY

Acct 385 BlocherEl1-33 Pforsich

BASIC CAPITAL BUDGETING

Rockyford Company must replace some machinery that has zero book
value but a current market value of $L,800.One possibilityis to investin new
machinery costing $40,000.This ne\tr machinery would produce estimated
annual pretax operating cash savingsof $12,500.Assumethe new machine J14orro
will have a usefullife of four yearsand depreciationof $L0,000eachyear for *'4o1-
book and tax purposes.It will have no salvagevalue at the end of four years. *u ral'c.
The investmentin this new machinery would require an additional $S,OOOi7;-
investmentof working capital. ',-in
'1z-
If Rockyford accepts this investment proposal, the disposal of the old
machinery and the investmentin the new one will occur on December3L of
this year. The cashflows from the investmentwill occur during the next four
calendaryears.

Rockyford is subject to a 40 percent income tax rate for all ordinary

income and capital gains and has a L0 percent after-tax cost of capital. All
operatingand tax cashflows are assumedto occur at year-end.

Required-- Determine:

L. The presentvalue of the after-tax cashflow arising from disposingof the

o l d m a c h i n e r y(.t t o t - O 0 v ) = f l f o o( a 4 k ; * x ( , - v ' 1 " 1 ' " ) = - t i ] [ :
2. The present value of the after-tax cash flows for the next four .years
--
nttributableto the operatingcashsavings.ft>;roo x 6oL x \'11 $ M
3. I.he presentvalue of the tax shieldeffectof depreciationat the end of year
1. ooo= V\-)
(f 4-o, x f oL *to o e'1 o7 C,r"') -- * #
4. Which one of the following is the proper treatment for the $31000working
capitalrequired in the current year?
a. It should be ignored in capital budgeting becauseit is not a capital
investment.
It is a sunk costthat needsno considerationin
reAfudas part of the initial investmentwhen determining
the net nt value.
0. tIT[-oUA be spreadover the machinery'sfour-year life as a cashoutflow
in each of thq years.
e. It should be included as part of the cost of the new machine and
depreciated.
(CMA Adapted)

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Acct 385 BlocherPl1-45 Pforsich

CASH FLOW ANALYSIS AND NPV

Lou Lewis,thepresidentof the LewisvilleCompany,hasaskedyou to give him an

of thebestuseof a warehouse
analysis thecompanyowns.
^^^;t< l=i*,
tu,;fr;' Companyis currentlyleasingthe warehouseto anothercompanyfor
er month on a year-to-yearbasis.
r
U.{fne warehouse'sestimatedsalesvalueis $200,000.A commercialRealtor
, * / believesthatthepriceis likely to remainunchangedin the nearfuture.The
ttl,u"F I UritAlngoriginallycost$60,000+1d at $1,;00annually.
is beingdepreciated Its
,({"'-,/. f current net book value is $7,500. \ s L Jery.c ove"t$oy ,s /
1'/ [ 6(o,6ro -(:ss'rx rfau/t; =+z,s* B'oL Va-A,,'t-
c. LewisvilleCompanyis seriouslyconsidering
convertln&thewarehouse
into a
factory outlet for furniture.The remodelingwill nd will be
extremelymodestbecausethe major attractionwill bl rock- bottom prices.The
remodelingwill be iatedover the next fi usins the double-
declininq-balance met PV@ tLo
6v,(r-"'€*I PV + 5 (*1vss*\a-,

The inventory,cash,and receivables n and sustainthe factorv

outletwould be $600,000.This total 1 S llv recoverab when- ever operations
terminate.

, \ e . Lou is fairly certainthe warehousewill be condemnedin 10 yearsto make

room for anewhighway. The firm most likely would receive$200,000from the
Xrrgl condemnation.
t
f. Estimatedannualoperatingdata,exclusiveof depreciation,are:
Sales $900,000
Operationexpenses Jffi:.H; 6olo
= v,t--,,svv
-[lgg,-f
Nonrecurringsalespromotion Qostsat thedee of year 1 are expectedto
6 (*n^'aeJ.u,'{t6(.). sa^t u *-*, +
l-}
-(oo,crsox 6 " % ) = 6 o , t ' r . of u f t @t ; r-., ,-". I r
cosrs
termination
h. Nonrecurring 6"L xvl='ry^-ift J J
unn@fueadur. [50,000.x
The minimum annualrate of return desiredis 14 percent.The companyis in the
40 percenttax bracket.
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 formbelowfor Lewisville
theanalysis
Complete Company the bestuseof thewarehouse.
to determine

PV
Factor
o
PV
CASHFLOWS
INYEAR

-
_..-.....--.--...----

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 f4't copy
Acct 385 BlocherPll-46 Pforsich
'a

MACHINE REPLACEMENT WITH TAX CONSIDERATIONS

-3'-ke'off,'
A computerchip manufacturerspentffift" developa special-
purposemolding machine.The machinehas bee_n for one r and will
or this
machine.
At the beginning of
gost$2,000,000,
will reduceannual cash
manufacturing costs from to $1,000,000,and will have zero
disposalvalue at the end of Managementhas decidedto use the
double-declining-balance depreciation\method for tax purposes if this
machineis purchased. h:3
The old machine'ssalvagevalue is $300,000now and will be $50,000three
yearsfrom now; however,no salvagevalueis provided in calculatingstraight-
line depreciationfor tax purposes.

Required:

Assumethat income tax rates are 45 percent. The minimum rate of return
desired,after taxes,is 8 percent.Using the net presentvalue technique,show
whetherthe firm shouldpurchasethe new machine.
U- trL

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11'-46MachineReplacement (15 min)
with traxConsiderations
Valueof Costswiththe Original
Present Equipment
Presentvalueof tax savingson depreciation:
$2,500,000+ 4x0.45x2.577= $724,781
Presentvalueof operatingcosts:
$1,800,000 x (1 - 0.45)x2.577= <2,551,230>
Presentvalueof salvagevalue:
$50,000x (1 - 0.45)x0.794 = 21,835
Presentvalueof costswiththe originalequipment <$l-SOaOU>
Presentvalueof the costswiththe newmachine
lnitialoutlay

Presentvalueof taxsavingson depreciation:

BeginningDepreciation Tax Tax Discount Present
Year BookValue Expense Rate Saving Factor Value
1 $2,000,000 $1,333,333x 0.45= $600,000 x 0.926 $ 555,600
2 666,667 444,445x 0.45= 200,000x 0'.857 171,400
3 222,223 222,223x 0.45= 100,000 x 0.794 79,400
Cash proceeds fromsaleof the old machine 300,000
Taxsavingof losson disposalof the oldmachine
($1,875,000 - $300,000) x 0.45= 708,750
Presentvalueof operatingcosts
$1,000,000 x (1 - .45)x2.577=
Totalcostat presentvalue

fromusingthe newmachine:
Savings
- $t ,656,200
$1,804,61a = $148,414

The totalcostof the new machine, including the purchasecostandthe

operatingcostin eachof thethreeyears,is $148,414belowthetotalcostof
continuingwiththe originalequipment. Financiallypurchaseof the new
machineis a good investment.

Blocher,Chen,Lin: Cost Management lI-49 @TheMcGraw-Hill Companies,Inc.,2002

10
 1. KYZ Manufacturing Company proiid"" vending machines for soft-drink
mangfacturers.The companyhas been investigatinga new piece of machineryfor
its productiondepartment.The old equipmenthasa remaininglife of ten yearsand
the new equipment has a value of $391,200with a ten-year life. The expected
additionalcashinflows are $75,000per year.What is the internalrate of return?

,e (o-) 1C

6,d) ffits Trrf$ 15 1t 1f

?AnPc
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2. InvestmentA requiresa net investmentof $l ,435,00A.The requiredrate of return is

18% for the five-year annuity. What are the annualcashinflows if the net present
value equals0? (rounded)

7 ?

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11
 TheZZZ Corporationwantsto purchasea new machinefor its factory operationsat
a costof $800,000.The investmentis expectedto generate$400,000in annualcash
flows for a periodof five years.Therequiredrateof returnis 10%.Theold machine
canbe soldfor $75,000.The machineis expectedto havezero valueat the end of
the five-year period. What is the net presentvalue of the investment?Would the
cornDanvwant to purchasethe new machine? Income taxes are not considered.

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Yes

12
 4. The )OO( Corporationwants to purchasea new machinefor its factory operations
at a cost of $800,000.The investmentis expectedto generate$400,000in annual
cash flows for a period of five years. The required rate of return rs l0%. The old
machinecan be sold for $75,000.The machineis expectedto havezero value at the
end of the five-yearperiod.Income taxes are considered. The new machine is
depreciatedunder the straight-line method and the tax rate is25Yo.
What is the net presentvalue ofthe investment?
Would the companywant to purchasethe new machine?
What is the approximateIRR of the investment?

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5. "-:k
The DDB Corporation*ants to purchaseai6flmfChine for its factory operationsat
a costof $800,000.The investmentis expectedto generate$400,000in annualcash
flows for a period of five years.The requiredrate of return is lUYo.The old machine
qan be sold for $75,000.The machineis expectedto havezero value at the end of
the five-year period. . The new machine is
depreciatedunder th method and the tax rate is
25"/".
What is the net presentvalue ofthe investment? 8vx"(*a
Would the companywantlo purchasethe new machine? * AVx to?'
What is the apprgxi the investment?

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