Capital Budgeting

Reto S.A.

In December 2004, R. E. Torgler was trying to decide whether to add a new line of injection
molded plastic products to those already manufactured and distributed by Reto S.A. In order to do
so, the firm would have to buy new injection molding equipment; none of the existing equipment
could be adapted to perform the necessary operations, and Torgler was anxious to retain control of
manufacturing. Actually, new injection molding equipment of the type needed had been considered
before, but a decision to purchase the equipment had been postponed because the product concept
was judged to need additional development. But now the products seemed ready.

Sales of the new product were forecast at SFr. 2,000,0001 per year, from which a sales commission
of 15 percent would be paid to Reto's sales agents. Direct manufacturing costs were budgeted at SFr.
600,000 for materials and SFr. 900,000 for labor, leaving an annual cash flow before taxation of SFr.
200,000. The new equipment would cost SFr. 600,000, delivered and installed, and was expected to
have an economic life of 10 years before it would become worthless.

Reto was able to borrow money at 8 percent, although it did not plan to negotiate a loan
specifically for the purchase of this equipment.

Questions

1. Ignoring the effect of taxes, what is the "internal rate of return" (IRR) on the proposed
investment. Assume the new equipment would be installed by January 1, 2005, and begin
producing on that date.

2. The cost of the equipment can be deducted from annual cash flows before they are subjected
to taxation. Assuming that the equipment will last 10 years, and that an equal amount of the
cost of SFr. 600,000 will be deducted each year, and that the tax rate is expected to be 45
percent, what is the IRR on an after-tax basis?

3. Torgler has stated that Reto should be willing to purchase this machine as long as it yielded a
return of 12 percent after taxation. Should he make the investment?
1 Actual sales were made in several different currencies, but for simplicity here all money measurements are stated in their
Swiss franc equivalents. The approximate exchange rate at the time of writing the case was SFr. 1.30 = U.S. $1.00.
197-102 Reto S.A.
2
4. Actually, to stimulate industrial development, the tax rules allow up to one third of the cost of
any such investment to be deducted from cash flows in the first year after the investment, and
up to one-fifth of the remainder of the unamortized investment amount can be deducted in
the second year. Thereafter, annual deductions are computed on a straight-line basis such that
no more than the original cost of the equipment is depreciated over its economic life. How, if
at all, does this tax rule affect the attractiveness of the investment?

5. Reto has learned that investment in working capital (receivables and inventories, less
payables) amounts to approximately 15 percent of sales. Will the additional SFr 300,000
investment for the new line decrease the rate of return on investment to less than the 12
percent criterion Torgler has been using?

6. In late December 2004, Reto purchased the equipment, and the operating results turned out as
forecast. A year later, Torgler learned that the manufacturer of the equipment had introduced
new models which were more automated. The new equipment sold for SFr. 1,000,000 and
would permit labor savings of SFr. 200,000 per year, thus doubling the net operating cash flow
on the product. As a result of the technological advance, Torgler expected the one-year-old
machine could be sold for only SFr. 200,000 despite the fact that its book value was SFr.
400,000. If Reto buys the new machine and depreciates it using allowed tax depreciation over
10 years, would the investment meet the 12 percent after-tax criterion?

7. If the one-year-old machine had no salvage value at all, would replacing it with the new
machine still be desirable?

8. Torgler was loathe to throw away a nearly new machine and thought he might be better off to
keep it one more year and then replace it. Would he be better off? How would you go about
addressing this issue?

9. During 2005, the rate of inflation remained low, and it was expected that it would average
about 4 percent for the year. Torgler wondered how Reto's analysis should reflect this rate of
inflation, which he expected might continue for several years. Advise Torgler on this issue.