Capital Budgeting (Practice Problems with Answers)

CAPITAL BUDGETING PRACTICE PROBLEMS Self-Study Question Nu-Concepts, Inc., a southeastern advertising agency, is considering the purchase of new computer equipment and software to enhance its graphics capabilities. Management has been considering several alternative systems, and a local vendor has submitted a quote to the company of $15,000 for the equipment plus $16,800 for software. Assume that the equipment can be depreciated for tax purposes over three years as follows: year 1, $5,000; year 2, $5,000; year 3, $5,000. The software can be written off immediately for tax purposes. The company expects to use the new machine for four years and to use straight-line depreciation for financial reporting purposes. The market for used computer systems is such that Nu-Concepts could sell the equipment for $2,000 at the end of four years. The software would have no salvage value at that time. Nu-Concepts management believes that the introduction of the computer system will enable the company to dispose of its existing equipment, which is fully depreciated for tax purposes. It can be sold for an estimated $200 but would have no salvage value in four years. If Nu-Concepts does not buy the new equipment, it would continue to use the old graphics system for four more years. Management believes that it will realize improvements in operations and benefits from the computer system worth $16,000 per year before taxes. Nu-Concepts uses a 10 percent discount rate for this investment and has a marginal income tax rate of 40 percent after considering both state and federal taxes. a. Prepare a schedule showing the relevant cash flows for the project. b. Indicate whether the project has a positive or negative net present value. Compute Net Present Value Dungan Corporation is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new equipment at time 0, including delivery and installation, is $200,000. If it is purchased, Dungan will incur costs of $5,000 to remove the present equipment and revamp its facilities. This $5,000 is tax deductible at time 0. Depreciation for tax purposes will be allowed as follows: year 1, $40,000; year 2, $70,000; and in each of years 3 through 5, $30,000 per year. The existing equipment has a book and tax value of $100,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $40,000 and is being depreciated for book and tax purposes using the straight-line method over its actual life. Management has provided you with the following comparative manufacturing cost data: The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years. The new equipment is expected to have a salvage value of $60,000 at the end of 10 years, which will be taxable, and no removal costs. No changes in working capital are required with the purchase of the new equipment. The sales force does not expect any changes in the volume of sales over the next 10 years. The company's cost of capital is 16 percent, and its tax rate is 40 percent. Required a. Calculate the removal costs of the existing equipment net of tax effects. b. Compute the depreciation tax shield. c. Compute the forgone tax benefits of the old equipment. d. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10. e. Calculate the tax benefit arising from the loss on the old equipment. f. Compute the annual differential cash flows arising from the investment in years 1 through 10. g. Compute the net present value of the project. Compute Net Present Value: Dungan Corporation. a. Equipment removal net of tax effects = $3,000 = $5,000 x (1 – 40%). b. Depreciation schedule: Year Depreciation 1 2 3 4 5 Totals $ 40,000 70,000 30,000 30,000 30,000 $200,000 Tax Shield at 40% Present Value Factor (16%) $16,000 28,000 12,000 12,000 12,000 $80,000 .862 .743 .641 .552 .476 c. Forgone tax benefits: $4,000 = ($100,000 ÷ 10 years) x 40% d. Gain from salvage of new equipment: $36,000 = $60,000 x (1 – 40%) e. Tax benefit arising from loss on old equipment: $24,000 = ($100,000 book value – $40,000 salvage value) x .40 tax rate f. Differential cash flows (years 1 – 10): $19,800 = [($30,000 + $48,000) – ($25,000 + $20,000)] x (1 – 40%) Present Value $13,792 20,804 7,692 6,624 5,712 $54,624 A-15. (continued) g. Year 5 0 1 2 3 4 6 7 8 9 Investment flows: Equipment cost ...... $(200,000) Removal ................. (3,000) Salvage of old 40,000 equipment .......... Tax benefit—sale 24,000 of old equipment Periodic operating flows................... $19,800 $19,800 $19,800 $19,800 $19,800 $19,800 $19,800 $19,800 $19,800 Tax shield from depreciation: New equipment: 16,000 Year 1 ................. Year 2 ................. 28,000 Years 3–5 ........... 12,000 12,000 12,000 Old equipment (forgone) ........... (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) Disinvestment: Proceeds of disposal.............. Tax on gain ............ Total cash flows ....... $(139,000) $31,800 $43,800 $27,800 $27,800 $27,800 $15,800 $15,800 $15,800 $15,800 PV factor at 16% ...... .862 .743 .641 .552 .476 .410 .354 .305 .263 Present values ......... $(139,000) $27,412 $32,543 $17,820 $15,346 $13,233 $ 6,478 $ 5,593 $4,819 $ 4,155 Net present value..... $ 158 10 $19,800 (4,000) 60,000 (24,000) $51,800 .227 $11,759 Present Value of a Lump Sum Table Present Value of an Annuity Table