University of the West Indies

Department of Management Studies

MS28D Financial Management I

Tutorial #10 - Capital Budgeting: Cash Flow Estimation - Chapter 11

1. Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity costs and externalities should be included

2. Explain how net operating working capital is recovered at the end of a project's life and why it is included in a capital budgeting analysis.

3. 11-2

4. 11-3

5. Milky Lane is considering the acquisition of a state-of-the-art ice cream making machine. Two new models are available: Machine A and Machine B

Machine A has an expected life of 16 years, zero salvage value and costs $132,000. Machine B also has an expected life of 16 years, zero salvage value and costs $224,000. For its first 8 years, Machine A will increase sales by $9,500 and at the same time reduce operating expenses by $4,500. For the second 8 years of Machine A, the incremental sales and savings on operation expenses are expected to increase by 50% over its first 8 years. Machine B will increase sales by $72,750 and is expected also to increase operating expenses by $13,750 throughout its16- year life.

The tax rate is 40% and depreciation is estimated using the straight-line method. Milky Lane cost of capital is 14%.

Required:

a. Calculate the NPV and IRR of both machines.

b. Which one should be chosen, if any at all ?

6. The Jamaica Orange Growers Ltd. (JOG) is considering the purchase of a new orange juicing machine for $1,000,000. The new machine will not result in any increase in sales but will provide labour cost savings of $400,000 per year before-tax and depreciation. To operate this machine efficiently, workers would have to go through a training sessions that would cost $100,000.

In addition, it would cost $50,000 to assemble the new machine before it can be used. The increased efficiency resulting from the use of the machine would necessitate an increase in inventory of $150,000. This machine has an expected useful life of 10 years, after which it will have no salvage value.

The firm uses the straight-line depreciation method and the machine is being depreciated down to zero. The firm’s cost of capital is 15% and the tax rate is 34%.

 a.          Find the initial cost of this investment and the annual after-tax cash flows in years 1 to 10.

b.         Find the NPV of the project.

c.          Find the PI of the project.

d.         Find the IRR of the project.

7. Jamaica Dairy Co. Ltd. is contemplating replacing one of its bottling machines with a newer and more efficient machine although its old machine is doing the job satisfactorily now.

The old machine has a book value of $150,000 and remaining useful life of 5 years. The firm does not expect to realize any returns from scrapping the old machine in 5 years, but if it were sold now the company could receive $90,000 for it.

A new machine with a purchase price of $300,000, estimated life of 5 years and salvage value of $50,000 is available. The machine is expected to economize on electric power usage, labour and repair costs and also to reduce defective bottles. In total, an annual savings of $70,000 will be realized if the new machine is installed. However, staff will have to be trained at a cost of $11,625 to operate the machine effectively. The tax rate is 40%, cost of capital is 14% and the company uses the straight-line depreciation method.

Should Jamaica Dairy Co. Ltd bother to replace its old machine?

8. Jamdown Garment Co. is considering the replacement of an existing machine. The new machine costs $1 .2M and requires installation costs of $150,000.

The existing machine can be currently sold for $185,000 before taxes. It is 2 years old, cost $800,000 new, has a $480,000 book value and has a remaining useful life of 5 years. It is being depreciated over a 5-year period using straight-line depreciation and therefore has 3 years of depreciation remaining. If held until 5 year from now, the machine’s market value would be zero.

Over its 5-year life, the new machine should reduce operating costs by $350,000 per year. The new machine will be depreciated over 5 years using straight-line depreciation. The firm can take an 8% initial capital allowance on the installed cost of the new machine. The machine will have a salvage value of $200,000 at the end of 5 years. An increased investment in net working capital of $25,000 will be needed to support operations if the new machine is acquired.

Assume that Jamdown has a 14% required return and a 40% tax rate.

a.            Develop the relevant cash flows needed to analyze the proposed replacement.

b.            Calculate the NPV and IRR of the proposal.

c.          Should the existing machine be replaced? Explain?

9. ALF Corporation is considering replacing their existing Point-of-Sale terminals (POS) with more modern ones that are Year 2000(Y2K) compatible.  The current POS terminals which were bought 4 years ago, have an estimated useful life of 9 years.  They also have a current book value of JA$800,000, are being depreciated on the reducing balance basis at a rate of 50% per annum and have 4 years of depreciable life remaining (it is ALF's policy to have the depreciation in the eight year equal to that of the seventh year).  The Y2K compatible POS terminals could be purchased in Japan for 30,000,000YEN (10 YEN to 1 JA$), but would also incur an additional 10,000,000 YEN in shipping costs.  The new POS terminals would be depreciated on the straight-line basis over a useful life of 5 years down to a value of zero.  If the present POS terminals were sold now, they would fetch 60% of their current book value, while if the new POS terminals were sold at the end of their useful lives they would be sold for a nominal JA$1,000.  The new POS terminals would provide additional annual gross cash flows (before taxes) of JA$3,000,000, but would necessitate an initial after-tax staff training cost of JA$300,000.  The tax rate is 40% and ALF's cost of capital is 20%. 

   As Finance Director, you have been asked to present at the next executive board meeting, a report outlining whether this replacement is financially worthwhile to ALF Corporation.

    Required: Prepare a draft of such a report which must clearly state your recommendation as well as the supporting calculations upon which you based your decision.