Tutorial 6
1.
Capital Budgeting III
The company bought some production equipment 2 years ago for
$100,000. Due to technological advances, current equipment that costs
$25,000 can do the same job faster and cheaper. The old equipment can
be sold for parts yielding $8,000. What should be included in the capital
budgeting proposal for a replacement project.
Issue: sunk costs.
The initial cost should be the $25,000 cost less the $8,000 salvage
value recovered today. The $100,00 that was the original cost of
the equipment is not considered.
2.
Installation of the new equipment is expected to use 75 man-hours of
labour. Due to a current slowdown, this labour can be provided without
affecting production. No layoffs are being considered at this time. Direct
labour costs are $22.00 per hour but are costed at $50.00 per hour with
overhead costs. How much should this add to the cost of the replacement
project?
Issue: sunk costs
The company is going to incur the labour costs whether or not it
goes ahead with the project. Therefore the labour charges should
be ignored in the capital budgeting proposal.
3.
The replacement project will require some support machinery to operate
at peak efficiency. The company makes this machinery at one of its other
factories. The machinery costs $12,000 to produce and sells for $16,000.
At the moment the company has more orders than it can fill. How much
should be charged in the proposal?
Issue: opportunity costs.
Since the machinery can be sold for $16,000 the project should
include the entire $16,000. If they company had slack production
capacity then the $12,000 cost would be appropriate.
Tutorial 6
4.
Capital Budgeting III
The company owns a vacant plot of land that originally cost $100,000.
The current market value is $600,000. What should be included in a
capital budget for a project that uses this land?
Issue: opportunity costs
The initial cost should include the $600,000 for which the land
could be sold, less any costs that the sale would incur such as real
estate commissions, capital gains taxes, legal fees, etc.
5.
The company intends to sell the land at the end of 5 years for $900,000.
How would this be included in the capital budgeting proposal?
Issue: valuation, opportunity cost
The expected $900,000 price (net of costs) should be discounted
to the present at the cost of capital and added to the initial cost.
If the project will wrap up in less than 5 years, the cost to return
the land to a saleable condition should be included instead.
6.
The company is reserving the land for the expansion of it’s manufacturing
capacity. For this reason any proposal must be limited to a 5 year
duration.
Issue: included costs, opportunity cost
The $600,000 can be ignored because it is not an option that is
under consideration. However, the fifth year of the proposal should
include an estimate of how much it would cost to put the land in an
appropriate state for construction. This cost can be negative if it
is less than currently estimated if the project is rejected.
Tutorial 6
7.
Capital Budgeting III
The above plot of land is being rented out for $5,000 (net) per year and
the company has a definite use for the land that starts 5 years from now.
What should our proposal include?
Issue: included cash flows, opportunity costs
The $5,000 per year rent must be included as a negative impact in
any cash flow forecast. If the project is rejected the company will
get the $5,000, if it is accepted, the $5,000 per year will be lost.
8.
The company doesn’t own the land, but can buy it for $600,000 and
finance it with a mortgage bond with a coupon payment of 6%. How
should this be handled?
Issue: financing
The $600,000 cost should be included. The 6% financing option
does not enter into the decision.
9.
The proposed project would increase inventories by $57,000 and
accounts receivable by $32,000. It would also allow accounts payable to
increase by $42,000. How, if at all, should this be accounted for in the
proposal?
Issue: relevant costs
This would be an increase of $57,000 + $32,000 – $42,000 or
$47,000 in net working capital. This is a required investment and
must be financed by the company. Therefore the $47,000 should
be added to the initial cost of the project. If the project is of a
limited duration, the $47,000 can be added back as a cash inflow in
the final year.
Tutorial 6
Capital Budgeting III
10. ABC Inc. has six projects under consideration. A & B are independent of
C & D. A & B are mutually exclusive options as are C & D and E & F. If E
is undertaken it would increase the value of A and D by $5,000 each,
while if F is undertaken it will increase the value of B or C by $3,000 each.
Project
NPV
I0
PRI
A
7,000
32,000
B
9,500
24,000
C
6,700
29,000
D
7,000
30,000
E
-2,500
15,000
F
1,000
12,000
1.22
1.40
1.23
1.23
0.83
1.08
a) Find the PRI of all of the projects alone.
PRI = PV inflows / I0
NPV = PV inflows - I0
PRI = (NPV + I0) / I0
b) List all of the possible combinations of projects that ABC can consider.
Do nothing, A, B, C, D, E, F, AC, AD, AE, AF, BC, BD, BE, BF, CE, CF,
DE, DF, ACE, ACF, ADE, ADF, BCE, BCF, BDE, BDF
c) What should they decide?
ABC should try to maximize the total NPV of the project
combinations. One project from each of the pairs should be
undertaken, since they all have a positive NPV (after considering
the complementary nature of project E).
NPV ADE = (7,000+5,000) + (7,000+5,000) - 2,500 = 21,500
NPV BCF = (9,500+3,000) + (6,700+3,000) + 1,000 = 23,200
ABC should chose to accept projects B, C, and F.