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Project Selection

Do I have to do a cash flow? and How? What should I recommend for John ? Can you help me make logical assumptions and justifications about what he should do? So can you please show me step by step how to solve this problem.

Here is the problem:

John is very conservative and has a great aversion to risk. He knows the banks are already charging him too high an interest rate for loans for this company which is now finishing up year 5. The company has made some money each of the last two years, including this year.

John has calculated his weighted cost of capital to be 12%. Contribution margin is 80% and the marginal tax rate is 30%.

Three of his managers are asking him to finance projects for them. They are as follows:

His production manager wants to purchase some new equipment to replace the used equipment John bought for $70,000 when he started up 5 years ago. This equipment was depreciated over 7 years using the straight line method and has a salvage value of $25,000. The new equipment will cost $140,000 and generate total manpower savings, including all benefits expenses, etc., of $25,000 per year after taxes.

John's sales manager wants to switch from salaried program to salary plus commission. The current average salary is $80,000 per year plus approximately 30% overhead expenses to cover all of the employer's variable salary benefit costs. The new program will reduce the base salary to $50,000 per year. Since the average sales territory is approximately $600,000 in sales, the sales manager wants to guarantee $30,000 in commission the first year to all 10 salesmen. He does, however, expect the new program to create a 20% increase in sales next year due to commission incentive. Furthermore, the sales manager wants john to purchase 10 automobiles for the salesmen at a cost of $30,000 each (3 year life). The company is currently paying $15,000 per year in leasing cost for each of the 10 cars.

John's supply & distribution manager has been using public warehouses to store product for shipment to customers. The annual cost has risen to $300,000 per year. Land can be acquired for $100,000 in a central location and a structured steel building can be erected for $ 150,000 to store all of the products in one location. Annual handling and carrying costs would be $200,000.
The building depreciation is forty years

What would you recommend John do? Make logical assumptions and justify all of these before starting work.

Solution Preview

I have attached the wrokings in the file.

Project 1 - Here we need to calculate the NPV, if we buy the new machine. The old machine had a depreciation of 10,000 per year ( 70,000 cost and straight line depreciation for 7 years would be 10,000). Since 5 yeras have gone, the acumulated depreciation would be 50,000 and the book value would be 20,000. This machine can be sold for 25,000. The new machine would cost 140,000. Assuming the same life of 7 years ( since it is similar to theold machine), the depreciation on the new machine would be 20,000 per year. The new machine would result in cost savings after tax of 25,000. The second cash flow would be due to the depreciation tax shield. ...

Solution Summary

The solution explains how the evaluate three projects using capital budgeting techniques. The great aversion to risks are determined.