Capital Budgeting

Problem 1

1) Your firm is looking into offering a new product.  This new project will run for only five years.

To produce this new product, you will need new equipment, which will cost $2,200,000 base cost, with shipping and installation costing another $35,000.

Your research has led you to believe that you can sell 85,000 units per year for $21.50 per bag.  The cost of the contents, packaging and shipping are expected to be $8.15 per bag.  The annual fixed costs of the venture are expected to be $350,000.  For simplicity, we will assume that the cost of the project will be 100 percent depreciated over the five-year life of the project.  Furthermore, the cost of removing the equipment will approximate the market value at the end of the project, so it will essentially be worthless on the books and in actuality.  We will assume a tax rate of 40%.

It is believed that as a result of this project that inventory will have to increase by $71,750, accounts receivable will increase by $35,875, and accounts payable will increase by $35,125.

Using the cost of capital in your firm (10%), should you invest in the new project?  Why?


Problem 2 

The company is considering replacing a machine.  The old one is currently being depreciated at $80,000 per year (straight-line), and is scheduled to end in five years with no remaining book value.  If you don’t replace it, you will be lucky to get it removed for the amount you could salvage it for, so you don’t expect any profit in five years.

If you replace it now, you believe you can salvage it for $425,000 (net) and buy a new machine for $850,000, plus $25,000 shipping fee and another $15,000 for installation.  The machine will reduce the operating costs of the company by $145,000 per year.  The new machine will be depreciated using the three-year MACRS (for simplicity purposes – the table is provided in Moodle).  The useful life of this machine is five years, and is expected to yield $15,000 in net salvage value at the end of the five years.  You may assume a tax rate of 35%.

Using the cost of capital in your firm, should you invest in the new machine? Why?

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