Capital Budgeting.docx

CAPITAL BUDGETING

CASE 1: Sinclair Company A. EQUIPMENT REPLACEMENT Question #1 Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment?

Investment............................................................................................................................................................. $250,000 Annual savings...................................................................................................................................................... 72,000 Present value of $1 a year, 5 years, 15 percent ..................................................................................................... 3.352 Total present value of savings .............................................................................................................................. 241,344 Decision: Do not purchase, since net present value is -$8,656. Question #2 Assuming the present equipment is being depreciated at a straight-line rate of 10%, that it has a book value of $135,000 *cost, $225,000; accumulated depreciation, $90,000), and has zero net salvage value today, should the company buy the proposed equipment?

Investment............................................................................................................................................................. $250,000 Annual savings...................................................................................................................................................... 72,000 Present value of $1 a year, 5 years, 15 percent ..................................................................................................... 3.352 Total present value of savings .............................................................................................................................. 241,344 Decision: Do not purchase, since net present value is -$8,656. Question #3 Assuming that the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero (0), should the company buy the proposed equipment?

Investment, gross .................................................................................................................................................. $250,000 Less salvage on old ........................................................................................................................................... 75,000 Net investment................................................................................................................................................ 175,000 Annual earnings .................................................................................................................................................... 72,000 Present value: $72,000 * 3.352 ............................................................................................................................. 241,344 Decision: Purchase, since net present value is $66,344.

Question #4 Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) above, should the company buy the proposed equipment?

Investment............................................................................................................................................................. $250,000 Annual earnings .................................................................................................................................................... 37,500 Present value, 10 years, 15%: $37,500 * 5.019 .................................................................................................... 188,213 Decision: Do not purchase, since net present value is -$61,787. B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT Question #1

Investment ............................................................................................................................................................................ $500,000 Annual earnings.................................................................................................................................................................... 160,000 Present value: $160,000 * 3.352 .......................................................................................................................................... 536,320

Decision: Purchase, since net present value is $36,320. (If Model A has resale value, the return would be even higher.)

C. CHANGES IN EARNING PATTERNS Question #1 What action should the company take?

Investment ......................................................................................................................................................................... $250,000 Present value of earnings Years 1-3: $79,500 * 2.283.......................................................................................................................................... $181,499 Years 4-5: $60,750 * 1.069*........................................................................................................................................ 64,942 Total PV of earnings ............................................................................................................................................... $246,441 Decision: Do not purchase, since NPV = - $3,559. *This is the difference between 3.352 and 2.283

Question #2 Why is the result here different from that in PART A (1)? Although the total earnings for the 5-year period are the same in Part C as in A (1), shifting more of the earnings to the early years and less to the later years increases the present value from $241,344 to $246,441.