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CAPITAL BUDGETING Murray Construction Company (for practice)

As owner of Murray Construction Company, you are considering the purchase of a new Binford 4000 ditch digger. The new machine will cost \$67,000, transportation (or freight) of \$3,000, and also will require \$4,000 in working capital to support the new machine’s operation. The equipment will be depreciated over a 3-year period using MACRS and will have an expected salvage value of \$1,500 at the end of its expected economic life of four years. The annual savings associated with the machine are expected to be \$30,000 per year for the next three years and \$20,000 in the fourth year. The company will not deduct the salvage value when calculating depreciation.

The existing ditch digger is almost worn out but can still be sold for \$12,000. The equipment was purchased three years earlier for \$50,000 and was being depreciated over a three-year period using the MACRS method.

Murray Construction uses a hurdle rate of 12% for its capital budgeting projects and has a marginal tax rate of 30%.

Questions

a. Determine the depreciation associated with the new equipment, as well as the unused depreciation on the old equipment.

b. Determine the cash inflows (after depreciation and taxes) associated with the new equipment.

c. Determine the cash outflows associated with the equipment. Show each of the items that would appear in the T-account. Then show both the cash inflows and cash outflows in the T-account.

d. Determine (1) the net present value, (2) the profitability index, (3) the internal rate of return, and (4) the payback period of the proposed project.

CAPITAL BUDGETING Current Recording Studios, Inc. (for practice)

As Vice-President of Finance for Current Recording Studios, you are considering the purchase of a new computer network for the company’s office staff. The existing computer equipment can be sold for a total of \$17,000. The equipment was purchased four years earlier for \$97,000 and was being depreciated over a five-year period using the MACRS method.

The new computer equipment will cost a total of \$83,000, require modifications to the building’s electrical wiring of \$2,300, and also will require \$3,500 in working capital to support the new equipment’s operation. The equipment will be depreciated over a 5-year period using MACRS and will have an expected salvage value of \$4,500 at the end of its expected economic life of six years. The company will not deduct the salvage value when calculating depreciation.

The annual savings are expected to be \$20,000 per year for each year of the equipment’s expected six- year life.

Current Recording Studios uses a hurdle rate of 14% for all potential capital budgeting projects and has a marginal tax rate of 35%.

Questions

a. Determine the depreciation associated with the new equipment, as well as the unused depreciation on the old equipment.

b. Determine the cash inflows (after depreciation and taxes) associated with the new equipment.

c. Determine the cash outflows associated with the equipment. Show each of the items that would appear in the T-account. Then show both the cash inflows and cash outflows in the T-account.

d. Determine (1) the net present value, (2) the profitability index, (3) the internal rate of return, and (4) the payback period of the proposed project.

CAPITAL BUDGETING Case Manufacturing, Inc. (for practice)

The president of Case Manufacturing, Inc. has determined that one of the firm’s assembly lines will have to be replaced. The line consists of a conveyor, small overhead motors for lifting equipment, and pneumatic lines for running the line’s machinery. The present equipment was purchased three years ago and is simply too inefficient for the higher production level of the firm today. The president has asked you to conduct a capital budgeting analysis to see if the replacement is justified.

Upon investigation, you have determined that the best value is offered by a manufacturer called Pinnacle Capital Goods, Inc. Pinnacle is willing to ship a “turn-key” type of system that will meet all of the company’s needs. The new assembly equipment will cost a total of \$88,000, require shipping costs of \$2,000, and also will require \$4,000 in working capital to support the new equipment’s operation. The equipment will be depreciated over a 5-year period using MACRS and will have a total salvage value of \$3,000 at the end of the expected economic life of six years.

The annual savings on the equipment are expected to be \$20,000 per year for the next six years.

The old equipment can be sold for \$24,100. It is now three years old and originally cost \$75,000. The company has been depreciating this equipment on a five-year MACRS basis also.

The firm has a hurdle rate of 12% for all potential projects and has a marginal tax rate of 40% (total of federal, state, and local taxes).

Determine the net present value and the internal rate of return for the proposed purchase. Should Case purchase the equipment? Why or why not?