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Capital Budgeting

Accounting - Relevant cash flows/NPO Terminal Value. See attached file for full problem description.

ABC Company is considering replacing an existing hoist with one of the two newer
more efficient pieces of equipment. The existing hosit is three years old, cost is
$32,000 and is being depreciated under MACRS using a 5 year recovery period.
It has a remaining economic lfie of 5 yrs. With no salvage value. The existing hoist
can currently be sold for $18,000.
Hoist A, one of the two possible replacement hosits, costs $40,000 to purchase and
$8,000 to install. It has a 5 hyr. Economic life and will be depreciated under MACRS
using a 5 yr. recovery period.
Hoist B costs $54,000 to install. It also has a 5 yr. economic life and will be
depreciated under MACRS using a 5 yr. recovery period.
The project Earnings before depreciatio, interest, and taxes for the existing and both
alternativ e hoists are:
EARNINGS BEFORE DEPRECIATION, INTEREST AND TAXES

Year Hoist A Hoist B Existing Hoist
1 21,000 22,000 14,000
2 21,000 24,000 14,000
3 21,000 26,000 14,000
4 21,000 26,000 14,000
5 21,000 26,000 14,000

ABC company is subject to a 40% tax rate for both capital gains and ordinary income.
Here are the questions relevant to the above problem.

a. Calculate the initial investment associated with each investment
b Calcula te incremental operating cash flows associated with each
alternative (be sure to consider the d epreciation in year-6)
c Calculate the NPV associated with each alternative, using a 12% discount rate
d Calculate the IRR associated with each alternative
e Calculate the payback associated with each alternative
f Made a very brief recommendation to the firms' Board of Directors-
What should it do? And why?

Problem number 2
Relevant cash flows-Npo terminal value
CLAc is considering replacing an existing piece of machinery with a more sophisticated
machine. The old machine was purchased 3 years ago at a cost of $50,000 and this
amount was being depreciated under MACRS using a 5 yr. recovery period. The machine
has 5 years of usable life remaining. The new machine that is being consdiered costs
$76,000 and requires $4,000 in installation costs. The new machine would be depreciated
under MACRS using a 5 yr. recovery period. The firm can currently sell the old machine
for $55,000 without incurring any removal ro cleanup costs. The firm is subject to a tax
rate of 40%. The revenues and expenses (excluding depreciation and interest)
associated with the new and the old machines for the next 5 years. Are given in the table
below.
New Machine Old Machine
Year Revenue Expenses Revenue
(excl.depr.&int.
1 750,000 720,000 674,000
2 750,000 720,000 676,000
3 750,000 720,000 680,000
4 750,000 720,000 678,000
5 750,000 720,000 674,000

Based on above information:
1 compute the NPV assuming a 12% discount rate
2 Compute the IRR
3 Compute the Payback period
4 Would you invest in this project? Why/why not?

MACRS: modified accelerated cost recovery system
depreciation methods
NPV: Net Present Value
IRR: Internal Rate of Return
Payback Period: Is the amount of time required for the firm to recover its initial
investment in a project as calculated from cash inflows.
The payback period is generally viewed as an unsophisticated captial
budgeting technique, because it does not explicitly consider
the itme value of money.

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Solution Summary

The solution has two capital budgeting problems - Choosing amoung hoists and replacement of a machine

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