Purchase Solution

# Capital Budgeting

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Graham Dodd, the controller of the New Economy Transport Company was evaluating a replacement of the Cynthia II, one of the boats NETCO used to push barges up and down the Mississippi and Ohio Rivers. The Cynthia II was carried on their books at a net value of only \$30,000, but it could probably be sold 'as is' along with an extensive inventory of spare parts for \$100,000. The book value of the spare parts inventory was \$40,000.
The chief engineer had estimated the current annual operating costs of the Cynthia II as:

Fuel \$450,000
Labor and Benefits 480,000
Maintenance 141,000
Other 110,000
Total \$1,181,000

Cohn and Doyle, Inc., a Wisconsin shipyard, had approached Mr. Dodd with a new design incorporating a Kort nozzle, extensively automated navigation and power control systems, for a fixed price of \$2,000,000, payable immediately. Estimated annual operating costs of the new boat would be:

Fuel \$370,000
Labor and Benefits 330,000
Maintenance 70,000
Other 74,000
Total \$844,000

Mr. Dodd thought that \$100,000 would have to be spent immediately training the new boats crew to handle the more complex and sophisticated equipment. Also, Mr. Dodd thought that a new boat might be able to push a larger load on some route which would generate additional revenues, net of out-of-pocket costs, of \$100,000 per year.

Assumptions
Make use of the following assumptions:

1. The new boat would be purchased immediately, t = 0.
2. The marginal tax rate is 34%.
3. Forecasted costs are constant in real dollars.
4. Sale price for the Cynthia II and parts is \$100,000 in real terms.
5. The Cynthia II would be sold when the new boat was delivered.
6. Investments qualify for the 5-year ACRS class.
7. Revenues are unaffected by the investment decisions, with the exception of the additional revenue from the new boat.
8. The new boat's forecast value at t = 16 is \$400,000.
9. Initial tax shields increase cash flow next year (t = 1).
10. Full operations with the new tugboat begin next year (t = 1).
11. Operating costs are taken at the beginning of the period.
13. Long-term expected inflation is 5%.
14. The nominal opportunity cost of capital is 19%.

##### Solution Summary

Calculates the value (i.e., savings or loss) of purchasing and running the new boat for 15 years using NPV.

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