# Evaluating cost and benefit for a capital budgeting decision

Capital Budgeting

Sky View Resorts, Inc. (SVR)

SVR owns and operates a resort lodge in Western Maryland. The BOD is considering the replacement of the seven years old HVAC system with a newer and more energy efficient system. The decision has been accelerated since the US Congress has approved tax incentives for business owners to perform such upgrades over the next 24 months.

The key issue for the BOD is whether or not the up-front cost of the new HVAC system, expected to have an installed cost of $800,000 will be offset by the energy cost savings over the life of the new system (estimated to be five years). The new system that is being considered is expected to reduce the number of KWH needed by 35% when compared to the operation (and KWH need) of the existing system. Chart 2 below (Forecasted KWH usage) illustrates the current expectation for KWH usage if the old system is maintained.

You have been tasked, as the CFO for SVR, to evaluate the cost / benefit of this capital budgeting decision. Your primary quantitative deliverables (you will find that the use of MS Excel will make the process less time consuming) to the BOD are as follows:

1. A schedule that computes the weighted average expected cost of electricity (generation plus transmission) over the next eight years. This computation is built around a probability distribution that considers volatile electricity costs (per KWH) as well as forecasted KWH usage by SVR. The information below is based upon your research including meetings with Big Sun Electric Utility.

Chart 1 - Forecasted KWH cost (the chart below is stated in dollars per KWH)

2014 2015 2016 2017 2018

Low end price per KWH projection (30% probability) .130 .135 .140 .145 .150

Mid range price per KWH projection (50% probability) .150 .160 .165 .175 .190

High end price per KWH projection (20% probability) .170 .185 .205 .230 .260

For each year you will calculate the weighted average expected cost per KWH. For example, for 2014 the weighted average expected cost is calculated as:

.30 times .13 plus .50 times .15 plus .20 times .17) = .148 per KWH

Chart 2 - Forecasted KWH usage (the chart below states KWH in millions)

The forecast of KWH usage must consider a wide range of forecasts from number of guest days to average annual temperature. The following chart is your forecast of KWH usage based upon your first round of research. This is the forecast if the current system is maintained. If the new system is purchased the demand for KWH will decrease by 35% below the values stated below.

2014 2015 2016 2017 2018

Low end estimate of KWH usage (40% Probability) 3.0 3.1 3.2 3.3 3.4

Mid-range estimate of KWH usage (40% Probability) 3.2 3.4 3.6 3.8 4.0 High end estimate of KWH usage (20% Probability) 3.5 3.8 4.1 4.4 4.7

For each year you will calculate the weighted average expected number of KWH consumption. For example, for 2014 the weighted average expected cost is calculated as:

.40 times 3 plus .40 times 3.2 plus .2 times 3.5 = 3.18 million KWH (the weighted average expectation)

Deliverable 1 (deliverable from you to the BOD) is a summary chart that shows the BOD your weighted average cost of electricity (total dollars) for the next five years (2014 - 2018). For 2014 that value will be the forecasted per KWH charge of .148 per KWH (see above) times the forecasted consumption of 3.18 million KWH (see above). The cost of electricity (if the old system continues to be used) is then forecasted to be $470,640.

2. Deliverable two (from you to the BOD) is a schedule that shows the BOD the annual expected cost savings if the new system is purchased. Your first pass estimated (based upon speaking with the system's manufacturer) consumption savings percentage (from the improved efficiency) is 35%. You are aware that this is an "educated" estimate. You'd like to make a firmer forecast but the dynamic of changing weather conditions (hotter and or colder), changing customer demand for rooms (how strong will the economy be? And the volatility of the cost of a KWH makes a firm comfort level likely unattainable. Given this you decide to prepare schedule that compares the savings at 35% (your best estimate) to the savings achieved at 30% (a more conservative savings rate) and 40% (a more optimistic savings rate).

Your schedule might look something like this:

Forecasted annual energy cost savings 2014 - 2018 (in thousands)

2014 2015 2016 2017 2018

Savings with a 30% efficiency

Savings with a 35% efficiency

Savings with a 40% efficiency

For 2014 the values would be calculated as follows:

Since the forecasted cost of electricity, if SVR continues to use the existing system, was previously calculated as $470,640 you would multiply this amount by the 30%, 35%, and the 40% energy savings rates respectively. For 30% - $141,192, for 35% $164,724, and for 40% - $188,256. This calculation will be performed for each of the years 2014 - 2018.

3. The next schedule (deliverable 3) needs to show the BOD the annual energy cash cost savings from the purchase of the new system, by year, and then the calculation of the present value of the net annual cash flow. The BOD has advised you to use a 10% rate (the hurdle rate) for discounting purposes.

You will need to prepare this schedule for each year for each level of efficiency. The firm is in the 35% combined federal and state tax bracket. For depreciation, assume that the tax incentive allows a business to depreciate the system over 5 years (as opposed to the normal 7 years at a minimum) Your schedule might look something like this.

Forecasted annual cash flow (assume that on 12.31.14 the firm has a cash outflow of $800,000 to purchase the system)

The 30% energy efficiency model (you will show models at 30%, 35%, and 40%) might look something like this:

2014 2015 2016 2017 2018

Energy cost savings $141,192

Depreciation Expense 160,000

Taxable gain (loss) (18,808)

Tax savings (expense) at 35% 6,583

Net Income after tax (12,225)

Add back depreciation 160,000

Net Cash Flow 147,775

Present Value Factor .9091

Present Value of Cash Flow $134,342

Total Present Values (sum of 2014 - 2018)

4. Schedule (deliverable) four shows the BOD the Net Present Value of each version of your calculations . The format of your schedule might look something like this:

NPV Summary HVAC Replacement with a 10% Hurdle Rate applied.

30% Efficiency 35% Efficiency 40% Efficiency

Total Present Value of Cash Inflows You supply these values

Less Present Value of Cash Outflow $(800,000) $(800,000) $(800,000)

Net Present Value of Cash Flow You supply these values

Your full report to the BOD should contain the above schedules (four in total) as well as commentary related to the following:

1. An intro to the project as a whole. Remember, this goes to the BOD. Use an efficient / effective / professional introduction and delivery for your work.

2. Identification and summary of key assumptions. The BOD's and yours (if any).

3. Key assumptions that present the greatest potential volatility. Discussion of potential impact(s).

4. Brief intro to each schedule. Remember, this is a professional memo.....not an academic assignment. Write with a very clear purpose.

5. Commentary throughout related to key outcomes and remaining uncertainties

6. A strong conclusion and recommendation to the BOD.

The full report is likely in the six (approximate) page range.

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#### Solution Preview

Executive Summary:

Sky View Resorts, Inc. has been presented with an opportunity to take advantage of a recent decision by the US Congress to offer a tax incentive on certain business upgrades. Specifically, Sky View could upgrade its current HVAC system to a more energy efficient one under this tax incentive. The issue that needs to be addressed is whether it would be profitable for SCR to do so. Based on our most recent data, it is believed that a new HVAC system would reduce our kilowatt hours needed by 35%. Based on expected values, that would result in $262,080 is savings. However, on the downside, it would have a net present value cash flow of -$82,654 based on a 10% cost of funds.

Assumptions:

We are assuming a 5 year life and depreciation for the project. It is possible the HVAC would last longer or possibly shorter than this. This would of course have an impact on the profitability of the project. Also, the 35% efficiency is an estimate. We have also run a 30% scenario and 40% scenario to give the BOD a reasonable range of outcomes to make its decision on. The cost ...

#### Solution Summary

The expert evaluates cost and benefits for a capital budgeting decision. They key assumptions for identifications are given. Potential impacts are provided.

Evaluate capital budgeting decisions for five scenarios

Capital Budgeting Decisions

Evaluate several capital budgeting decision scenarios. In a Word document, complete the exercises below and submit your responses per the instructions that follow.

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Equity Corp.

Equity Corp. paid a consultant to study the desirability of installing some new equipment. The consultant recently submitted the following analysis:

The corporate tax rate is 40%. Should Equity Corp. accept the project?

Used by permission of McGraw-Hill.

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Declining Market, Inc.

Declining Market, Inc. is considering the problem of when to stop production of a particular product in its product line. Sales of the product in question have been declining, and all estimates are that they will continue to decline. Capital equipment used to manufacture the product is specialized but can be readily sold as used equipment. If the decision rule for this case says "Keep producing the product as long as its contribution to net earnings is positive" what, if anything, is wrong with that? [Contribution to new earnings, where t is the tax rate, is (1 - t) (Sales - Variance cost - Depreciation on equipment used to manufacture product).]

Used by permission of McGraw-Hill.

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Demand for DVD Players

The demand for DVD players is expanding rapidly, but the industry is highly competitive. A plant to make DVD players costs $40 million, has an annual capacity of 100,000 units, and has an indefinite physical life. The variable production cost per unit is $20 and is not expected to change. If the cost of capital is 10%, what is the price of a DVD player?

Used by permission of McGraw-Hill.

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Clean Tooth

Several years ago, your firm paid $25,000,000 for Clean Tooth, a small, high-technology company that manufactures laser-based cleaning equipment. Unfortunately, due to extensive production line and sales resistance problems, the company is considering selling the division as part of a modernization program. Based on current information, the following are the estimated accounting numbers if the company continues to operate the division:

Assume

1. The firm is in the 0% tax bracket (no income taxes).

2. There are no additional expenses associated with the sale.

3. After year 10, the division will have sales (and expenses) of $0.

4. Estimates are completely certain.

Should the firm sell the division for $250,000?

Used by permission of McGraw-Hill.

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Flower City Grocery

The Flower City Grocery is faced with the following capital budgeting decision. Its display freezer system must be repaired. The cost of this repair will be $1,000 and the system will be usable for another 5 years. Alternatively, the firm could purchase a new freezer system for $5,000 and sell the old one for $500. The new freezer system has more display space and will increase the profits attributable to frozen foods by 30%. Profits for that department were $5,000 in the last fiscal year. The company's cost of capital is 9%. Ignoring taxes, what should the firm do?

Used by permission of McGraw-Hill.