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Capital budgeting decision

ABC Corp is considering the various benefits that may result from the shortening of its products cycle by changing from the company's present manual system to a computer-aided design / computer-aided manufacturing (CAD/CAM) system. The proposed system can provide productive time equivalence close to the 20,000 hours currently available with the manual system. The incremental annual out of pocket costs of maintaining the manual system are $20 per hour.

The incremental annual out of pocket costs of maintaining the CAD/CAM system are estimated to be $200,000, with an initial investment of $ 480,000 in the proposed system. The estimated useful life of this system is six years. They use a straight - line method and no salvage will be available. The tax rate will be 30% over the life of this project. ABC Corp requires a minimum after tax return of 20% on project of this type. Full capacity will be utilized.

1. Compute the relevant annual after-tax cash flow
2. Based on the computation in the #1, find the the following (after-tax)
a. payback period recovery of investment
b. net present value
c. profitability index

Please show calculations.

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Solution Preview

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
Decisions like the change in the methods of sales distribution, or an advertisement campaign or research and development programs have long-term implications for the firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Several different procedures are available to analyze potential business investments. Some concepts are better than others when it ...

Solution Summary

This explains how to use capital budgeting tools such as payback period recovery of investment, net present value, profitability index with the help of a case.