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Bauman Company and Annual Variable Operating Costs

See attachment for proper table format.
11-64

Bauman Company, which has a cost of capital of 15%, is thinking of replacing an existing piece of production equipment with new equipment. The following data relate to the analysis:

Old Machine New Machine
Future Life Exp 5 years 5 years
Current Salvage Value $50,000 Not applicable
Current purchase price Not applicable $500,000
Salvage value in 5 years $10,000 $125,000
Annual Var. Operating cost $350,000 unknown

What is the maximum amount of annual variable operating costs for the new machine that would make this an attractive purchase?

11-69

If the annual cash flows and salvage value in Exhibit 11-18 were subject to inflation at the annual rate of 4%, the cash flows would be those shown below. (Note that, under these conditions, the annual depreciation is now approximately $11,556.69 [($70,000 - $12,166.53) / 5)] Assume all cash flows except for the purchase occur at the end of the year.

Time Amount Depreciation Taxable Income Tax at 40% Net cash flow
0 ($70,000) ($70,000)
1 20,800 11,566.69 9,233.31 3,693.32 17,106.68
2 21,632 11,566.69 10,065.31 4,026.12 17,605.88
3 22,497.28 11,566.69 10,930.59 4,372.23 18,125.05
4 23,397.17 11,566.69 11,830.48 4,732.19 18,664.98
5 36,499.59 11,566.69 12,766.36 5,106.55 31,393.04

However, with inflation, the required rate of return must be increased so that it will provide for both the time value of money and the purchasing power loss due to inflation. In general, the required rate of return is as follows:

(1 + required rate of return) = (1 + real rate of interest) x (1 + inflation rate)
Required rate of return = (1 + real rate of interest) x (1 + inflation rate) - 1
Required rate of return = real rate of interest + inflation rate + (real rate of interest x inflation rate)

Where the real rate of interest is the return required in the absence of inflation.

A. Using the appropriate required return, compute the project's net present value.
B. Why is the net present value of the project lower under conditions of inflation than it was without inflation?

Below is the original copy of exhibit 11-18

Time Cash Flow Depreciation Taxable Income Tax @ 40% Net cash flow
0 ($70,000) ($70,000)
1 20,000 12,000 8,000 3,200 16,800
2 20,000 12,000 8,000 3,200 16,800
3 20,000 12,000 8,000 3,200 16,800
4 20,000 12,000 8,000 3,200 16,800
5
6 20,000
10,000 12,000
0 8,000
0 3,200
0 16,800
10,000

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Solution Summary

This solution shows step-by-step calculations and brief justifications in an Excel file to determine the maximum amount of annual variable operating costs and a project's net present value.

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