Reference no: EM13877576

Capital Budgeting for Expanding Productive Capacity

Ray Summers Company operates at full capacity of 10,000 units per year. The company, however, is still unable to fully meet the demand for its product, estimated at 15,000 units annually. This level of demand is expected to continue for at least another four years.

To meet the demand, the firm is considering the purchase of new equipment for $580,000. This equip- ment has an estimated useful life of four years and can be sold for $50,000 at the end of the fourth year. The engineering division estimates that installing, testing, and adjusting the machine will cost $12,000 before it can be put in operation.

An adjacent vacant warehouse can be leased for the duration of the project for $10,000 per year. The warehouse needs $58,000 of renovations to make it suitable for manufacturing. The lease terms call for restoring the warehouse to its original condition at the end of the lease. The restoration is estimated to cost $20,000. Current pre-tax operating profit per unit is as follows:

Strategy and the Analysis of Capital Investments 523

Per Unit

Sales price                                                                                    $200

Variable costs

Manufacturing                                       $60

Marketing                                              20               $80

Fixed costs

Manufacturing	$25
Marketing  and administrative	15		40		120
Operating profit before tax					$ 80

The new equipment would have no effect on the variable costs per unit. All current fixed costs are ex- pected to continue with the same total amount. The per-unit fixed cost includes depreciation expenses of $5 for manufacturing and $4 for marketing and administration.
Additional fixed manufacturing costs of $140,000 (excluding depreciation) will be incurred each year if the equipment is purchased. The firm must hire an additional marketing manager to serve new customers. The annual cost for the new marketing manager, support staff, and office expense is estimated at approximately $100,000. The company expects to be in the 40 percent tax bracket for each of the next four years. The company requires a minimum after-tax rate of return of 12 percent on investments and uses straight-line depreciation.

Required:

1. What is the required net initial investment outlay (year 0)?

2. What effect will the acquisition of the new equipment have on total operating profit after-tax in each of the four years?

3. What effect will the acquisition of the new equipment have on after-tax cash inflows in each of the four years?

4. Compute the payback period of the proposed investment under the assumption that cash inflows occur evenly throughout the year.

5. Compute the book (accounting) rate of return (ARR) of the proposed investment, based on the average book value of the investment.

6. Compute the net present value (NPV) of the proposed investment under the assumption that all cash inflows occur at year-end.

7. Compute the discounted payback period of the proposed investment under the assumption that cash inflows occur evenly throughout the year.

8. Compute the internal rate of return (IRR) of the proposed investment under the assumption that all cash inflows occur at year-end.

9. Use the MIRR function in Excel to estimate the modified internal rate of return for the proposed investment.

10. The company expects the variable manufacturing cost per unit to increase once the new equipment is in place. What is the most that the unit variable manufacturing cost can increase and still allow the com- pany to earn the minimum rate of return on this investment? (Hint: Use the Goal Seek option in Excel.)