BASIC CAPITAL BUDGETING Rockyford Company must replace ... · Blocher Pll-46 'a MACHINE REPLACEMENT...
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Acct 385 MV e-orrY Pforsich Blocher El1-33 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 savings of $12,500. Assumethe new machine J14 orro will have a usefullife of four yearsand depreciation of $L0,000 eachyear for *'4o1- book and tax purposes. It will have no salvage value at the end of four years. *u ral'c. The investmentin this new machinery would require an additional $S,OOOi7;- investment of working capital. ',-in If Rockyford accepts this investment proposal, the disposal of the old '1z- machinery and the investment in the new one will occur on December 3L of this year. The cashflows from the investmentwill occur during the next four calendar years. 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 operating and tax cash flows are assumed to occur at year-end. Required -- Determine: L. The presentvalue of the after-tax cashflow arising from disposing of the oldmachinery. (ttot- O 0v)=f lfoo (a4k;* x (,-v'1"1'") =-ti][: 2. The present value of the after-tax cash flows for the next four .years nttributable to the operating cash savings. ft>;roo x 6oL x \'11 -- $ M I.he present value of the tax shieldeffectof depreciation at the end of year 1. (f 4-o, ooo = V\-) x f oL *to o e'1 o7 C,r"') -- * # Which one of the following is the proper treatment for the $31000 working capitalrequired in the current year? a. It should be ignored in capital budgeting because it is not a capital investment. It is a sunk costthat needs no consideration in reAfud as part of the initial investment when determining the net nt value. 0. tIT[-oUA be spread over the machinery's four-year life as a cash outflow in each of thq years. e. It should be included as part of the cost of the new machine and depreciated. (CMA Adapted) 3. 4. 1
Transcript of BASIC CAPITAL BUDGETING Rockyford Company must replace ... · Blocher Pll-46 'a MACHINE REPLACEMENT...
Acct 385
MV e-orrY
PforsichBlocher El1-33
BASIC CAPITAL BUDGETING
Rockyford Company must replace some machinery that has zero bookvalue but a current market value of $L,800. One possibility is to invest in newmachinery costing $40,000. This ne\tr machinery would produce estimatedannual pretax operating cash savings of $12,500. Assume the new machine J14 orrowill have a useful life of four years and depreciation of $L0,000 each year for *'4o1-book and tax purposes. It will have no salvage value at the end of four years. *u ral'c.^The investment in this new machinery would require an additional $S,OOOi7;-investment of working capital. ',-in
If Rockyford accepts this investment proposal, the disposal of the old '1z-
machinery and the investment in the new one will occur on December 3L ofthis year. The cash flows from the investment will occur during the next fourcalendar years.
Rockyford is subject to a 40 percent income tax rate for all ordinaryincome and capital gains and has a L0 percent after-tax cost of capital. Alloperating and tax cash flows are assumed to occur at year-end.
Required -- Determine:
L. The present value of the after-tax cash flow arising from disposing of theoldmachinery. ( t tot - O 0v)=f l foo (a4k;* x ( , -v '1"1 '" ) =- t i ] [ :
2. The present value of the after-tax cash flows for the next four .yearsnttributable to the operating cash savings. ft>;roo x 6oL x \'11 -- $ MI.he present value of the tax shield effect of depreciation at the end of year1. (f 4-o, ooo = V\-) x f oL *to o e'1 o7 C,r"')
-- * #Which one of the following is the proper treatment for the $31000 workingcapital required in the current year?a. It should be ignored in capital budgeting because it is not a capital
investment.It is a sunk cost that needs no consideration in
reAfud as part of the initial investment when determiningthe net nt value.
0. tIT[-oUA be spread over the machinery's four-year life as a cash outflowin each of thq years.
e. It should be included as part of the cost of the new machine anddepreciated.
(CMA Adapted)
3.
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PforsichAcct 385
tu,;fr;' Company is currently leasing the warehouse to another company forer month on a year-to-year basis.
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U.{ fne warehouse's estimated sales value is $200,000. A commercial Realtor
, * / believes that the price is likely to remain unchanged in the near future. Thettl,u"F I UritAlng originally cost $60,000+1d is being depreciated at $1,;00 annually. Its
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c. Lewisville Company is seriously considering convertln&the warehouse into afactory outlet for furniture. The remodeling will nd will beextremely modest because the major attraction will bl rock- bottom prices. Theremodeling will be iated over the next fi usins the double-
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The inventory, cash, and receivablesoutlet would be $600,000. This totalterminate.
n and sustain the factorvwhen- ever operations
Lou is fairly certain the warehouse will be condemned in 10 years to makeroom for anew highway. The firm most likely would receive $200,000 from thecondemnation.
f. Estimated annual operating data, exclusive of depreciation, are:SalesOperation expenses
The minimum annual rate of return desired is 14 percent. The company is in the
CASH FLOW ANALYSIS AND NPV
Lou Lewis, the president of the Lewisville Company, has asked you to give him ananalysis of the best use of a warehouse the company owns.
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Acct 385
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Blocher Pll-46
' a
MACHINE REPLACEMENT WITH TAX CONSIDERATIONS-3'-ke'off,'
A computer chip manufacturer spent ffift" developpurpose molding machine. The machine has bee_n for one
machine.At the beginning of
gost $2,000,000, will reduce annual cash
double-declining-balance depreciation\method for tax purposes if thismachine is purchased. h :3
The old machine's salvage value is $300,000 now and will be $50,000 threeyears from now; however, no salvage value is provided in calculating straight-line depreciation for tax purposes.
Required:
Assume that income tax rates are 45 percent. The minimum rate of returndesired, after taxes, is 8 percent. Using the net present value technique, showwhether the firm should purchase the new machine.
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11'-46 Machine Replacement with trax Considerations (15 min)
Present Value of Costs with the Original EquipmentPresent value of tax savings on depreciation:
$2,500,000 + 4x0.45x2.577 =Present value of operating costs:
$1,800,000 x (1 - 0.45) x2.577 =
$724,781
<2,551,230>Present value of salvage value:
$50,000 x (1 - 0.45) x0.794 = 21,835Present value of costs with the original equipment <$l-SOaOU>
Present value of the costs with the new machinelnit ial outlay
Present value of tax savings on depreciation:Beginning Depreciation Tax Tax Discount
Year Book Value Expense Rate Saving Factor1 $2,000,000 $1 ,333,333 x 0.45 = $600,000 x 0.9262 666,667 444,445 x 0.45 = 200,000 x 0'.8573 222,223 222,223 x 0.45 = 100,000 x 0.794
Cash proceeds from sale of the old machineTax saving of loss on disposal of the old machine
($1 ,875,000 - $300,000) x 0.45 =Present value of operating costs
$1,000,000 x (1 - .45) x2.577 =Total cost at present value
Savings from using the new machine:$1 ,804,61a - $t ,656,200 = $148,414
PresentValue
$ 555,600171 ,40079,400
300,000
The total cost of the new machine, including the purchase cost and theoperating cost in each of the three years, is $1 48,414 below the total cost ofcontinuing with the original equipment. Financially purchase of the newmachine is a good investment.
708,750
Blocher, Chen, Lin: Cost Management lI-49 @TheMcGraw-Hill Companies,Inc.,2002
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1 . KYZ Manufacturing Company proiid"" vending machines for soft-drinkmangfacturers. The company has been investigating a new piece of machinery forits production department. The old equipment has a remaining life of ten years andthe new equipment has a value of $391,200 with a ten-year life. The expectedadditional cash inflows are $75,000 per year. What is the internal rate of return?
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The ZZZ Corporation wants to purchase a new machine for its factory operations at
a cost of $800,000. The investment is expected to generate $400,000 in annual cash
flows for a period of five years. The requiredrate of return is 10%. The old machine
can be soldfor $75,000. The machine is expected to have zero value at the end of
the five-year period. What is the net present value of the investment? Would the
cornDanv want to purchase the new machine? Income taxes are not considered.
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4. The )OO( Corporation wants to purchase a new machine for its factory operationsat a cost of $800,000. The investment is expected to generate $400,000 in annualcash flows for a period of five years. The required rate of return rs l0%. The oldmachine can be sold for $75,000. The machine is expected to have zero value at theend of the five-year period. Income taxes are considered. The new machine isdepreciated under the straight-line method and the tax rate is25Yo.What is the net present value ofthe investment?Would the company want to purchase the new machine?What is the approximate IRR of the investment?
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f, "-:k5. The DDB Corporation *ants to purchase ai6flmfChine for its factory operations ata cost of $800,000. The investment is expected to generate $400,000 in annual cashflows for a period of five years. The required rate of return is lUYo. The old machineqan be sold for $75,000. The machine is expected to have zero value at the end ofthe five-year period.depreciated under th25"/".What is the net present value ofthe investment?Would the company wantlo purchase the new machine?
the investment?* AV x to?'What is the apprgxi
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