# Capital Budgeting for High Tech Production Inc

1. High Tech Production Inc. purchased a computerized measuring device two years ago for $80,000. This equipment falls into the five-year category for MACRS depreciation. The equipment can currently be sold for $28,400. A new piece of equipment will cost $210,000 that would replace the exisitng equipment. It also falls into the five-year category for MACRS depreciation. It is anticipated this new piece of equipment will be sold at the end of the 5th year of operation for a price of $20,000. The tax rate is 34 percent and the cost of capital is 12 percent.

The new equipment would provide the following stream of operating cost savings before depreciation and taxes for the next five years.

Year Cost Savings

1 $76,000

2 66,000

3 62,000

4 60,000

5 56,000

a. Determine the depreciation schedule for the old equipment.

b. What is the book value of the old equipment?

c. What is the tax gain or loss on the sale of the old equipment?

d. What is the tax or the tax benefit from the sale?

e. What is the cash inflow from the sale of the old equipment?

f. What is the net cost of the new equipment? (Include the inflow from the sale of the old equipment.)

g. Determine the depreciation schedule for the new equipment.

h. What will be the book value of the new piece of equipment when it comes time to sell it, and what will be the tax gain or loss on the sale of the new equipment?

i. What will be the tax or the tax benefit from the sale and the net cash inflow from the sale of the new equipment?

j. What is the present value of the net cash inflow from the salvage of the new equipment?

k. Determine the incremental depreciation between the new equipment the remaining years of the old equipment, and the related tax shield benefits.

l. Compute the after-tax benefits of the cost savings.

m. Add the depreciation tax shield benefits and the after-tax cost savings, and determine the present value of these incremental benefits. (See Table 12-17 in Chapter 12 of the text as an example.)

n. Compare the present value of the incremental benefits (m), plus the present value of the expected proceeds from the salvage of the new machine (j) with the net cost of the new machine (f).

o. Should the replacement be undertaken?

Part II

Work out and submit the comprehensive problem below.

2. Halstrom Corporation purchased a piece of equipment three years ago for $230,000. It has an asset depreciation range (ADR) midpoint of eight years. This equipment can be sold now for $90,000.

A new piece of equipment can be purchased for $320,000 that would replace the existing equipment. It also has an ADR of eight years.

The new equipment, if purchased, will have a useful life of six years, with no salvage value at the end of that time. If the old equipment is kept, it will be operated for six more years in addition to the three years it has already been operated. It also will have no salvage value at the end of that time.

The old and new equipment would provide the following operating gains or losses (earnings before depreciation, interest, and taxes) over the next six years, beginning with the coming year.

Table 2

Year New Equipment Old Equipment

1 (1st year of new equip., 4th year of old equip.) $80,000 $25,000

2 76,000 16,000

3 70,000 9,000

4 60,000 8,000

5 50,000 6,000

6 45,000 (7,000)

The firm has a 36 percent tax rate and a 9 percent cost of capital. Do the calculations to determine if the new equipment should be purchased to replace the old equipment. Should the new equipment be purchased or should the old equipment be kept in operation?

Be careful here. This problem involves an investment that is supposed to increase profits, whereas the problem in Part 1 involved investing in a machine that would result in a cost savings. While the cash benefit resulting from the purchase of new equipment can come either in the form of a cost savings or an increase in profit, in this case be careful to work with the increase in cash flows resulting from the purchase of the new machine, not merely the profit from the new machine. The fact that the new machine will earn some profit is not sufficient reason to invest in it. It must increase profits enough to justify its purchase. This is easily seen if we consider a case where the new machine will in fact earn a profit, but the profit will actually be less than the existing machine is presently earning. Clearly, one would not purchase such a machine to replace the existing one. It is the increase in cash flows that counts.

Part III

Work out and submit the following comprehensive problem.

3. As you checked the Answer Key to Question 6 in the Mastery Check from this lesson you may have noted that each year's net cash flows are calculated by adding depreciation back to net earnings:

Question 6 Jayhawk Company has a proposed contract with the Comprehensive Systems of Kansas. The initial investment in land and equipment will be $120,000. Of this amount, $70,000 is subject to five-year MACRS depreciation. The balance is in non-depreciable property. The contract covers six years. At the end of six years, the non-depreciable assets will be sold for $50,000. The depreciated assets will have zero resale value.

The contract will require an investment of $55,000 in working capital at the beginning of the first year, and, of this amount, $25,000 will be returned to the Jayhawk Technology Company after six years.

The investment will produce $50,000 in income before depreciation and taxes for each of the six years. The corporation is in a 40 percent tax bracket and has a 10 percent cost of capital.

Using a piece of paper or a computer spread sheet, determine whether or not the investment should be undertaken. Use the net present value method.

Answer

Problem 6

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBIDT 50,000 50,000 50,000 50,000 50,000 50,000

Depreciation 14,000 22,400 13,440 8,050 8,050 4,060

Earnings before taxes 36,000 27,600 36,560 41,950 41,950 45,940

Taxes 14,400 11,040 14,624 16,780 16,780 18,376

Earnings after taxes 21,600 16,560 21,936 25,170 25,170 27,564

Depreciation 14,000 22,400 13,440 8,050 8,050 4,060

Cash flow 35,600 38,960 35,376 33,220 33,220 31,624

Investment -120,000 50,000

Net work capital -55,000 25,000

-175,000 106,624

NPV = 19,564 @ 10% cost of capital (The answer is $19,643 with a financial calculator.)

On the other hand, the problem in Part 1 of this assignment specifies a series of steps that leads you through the same approach as that used in the answer key for Question 8 in the Mastery Check of this lesson:

Question 8 The Acme Corporation is considering the purchase of an additional lathe to handle periodic overload conditions in the shop. By reducing overtime premiums, purchase of this lathe will result in cash savings of $20,000 per year before taxes. The new lathe would cost $50,000 and would be depreciated using 5 year MACRS. However, it is anticipated that it would be sold at the end of 5 years for an estimated $15,000.

Using a piece of paper or a computer spreadsheet, calculate the after-tax cash flows for this investment proposal using the method described in the discussion material for this lesson. (That is, calculate the after-tax cash flows as if there were no non-cash expenses.) Then adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. Calculate the net present value of this investment proposal using a 15% discount rate. Acme's marginal tax rate is 40%.

Answer

Problem 8

Year 0 Year 1 Year 2 Year3 Year 4 Year5

EBIDT 20,000 20,000 20,000 20,000 20,000

(1) After tax @ 40% tax rate 12,000 12,000 12,000 12,000 12,000

Depreciation 10,000 16,000 9,600 5,750 5,750

(2) Depreciation tax credit 4,000 6,400 3,840 2,300 2,300

Yearly cash flow (1) + (2) 16,000 18,400 15,840 14,300 14,300

Investment/salvage -50,000 10,160

Total cash flow -50,000 16,000 18,400 15,840 14,300 24,460

NPV = $8,589.34 @ 15% cost of capital. (Answer is $8,578.16 with a financial calculator)

Depreciation and Book Value

Year 0 1 2 3 4 5

Depreciation percent 0.200 0.320 0.192 0.115 0.115

Depreciation 10000 16000 9600 5750 5750

Remaining book value 40000 24000 14400 8650 2900

Sale price 15000

Book value 2900

Taxable profit on sale 12100

Tax on profit on sale 4840

Net proceeds from sale 10160

Rework and submit Question 6 using the same approach to calculate each year's after-tax cash flows as is used to solve Question 8.

That is, calculate the after-tax cash flows as if there were no non-cash expenses. Then, adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. (This is the method the problem in Part 1 leads you through as you follow the specified steps a through o for solving that problem).

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#### Solution Summary

Capital budgeting for High Tech Production Inc is examined.