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Capital Budgeting Dilemma: Tan-talize, Inc. and the New Molding Machine - Prof. Larry D. G, Assignments of Finance

A capital budgeting problem faced by tan-talize, inc. When considering the purchase of a new molding machine. The company had already purchased a machine for $40,500 and is depreciating it using the macrs method. A salesman from los angeles machine tool company offered a technically superior machine for $50,000, promising annual savings of $17,000 in cash operating costs. Ms. Miller, the production manager, is hesitant to make the switch due to sunk costs and the potential loss on the old machine. Financial calculations using net present value, internal rate of return, modified internal rate of return, profitability index, payback period, and tax implications to help determine whether the proposed equipment should be purchased.

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Uploaded on 08/16/2009

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CAPITAL BUDGETING
Tan-talize, Inc.
(Sunk Costs)
On January 2nd, Tan-talize, Inc. installed a brand new special molding machine for producing a new line of
suntan products. The machine had a cash cost of $40,500 and is to be depreciated using the 3-year column of the
MACRS table. The machine has an expected life of four years and a disposal value of zero at the end of four
years.
On January 3rd, Art Taitt, a salesman for Los Angeles Machine Tool Company, called on Glynda Miller,
production manager of Tan-talize. During the course of their conversation, Mr. Taitt told Ms. Miller: “I wish I
had known earlier of your purchase plans. Our company can supply you with a technically superior machine for
$50,000. The old machine has a salvage value of $8,000 today. I can guarantee that our machine will save you
$17,000 per year in cash operating costs, although it too will have no disposal value at the end of four years.
Mr. Taitt provided some technical data for Ms. Miller to examine. Although she had confidence in Mr. Taitt’s
data, Ms. Miller contended: “I’m locked into my previous decision. My alternatives are clear. Disposal will
result in a loss on the present machine. Moreover, keeping and using the present equipment avoids such a loss. I
have enough sense to avoid a loss when my only other alternative is to recognize a loss. I have to use the present
equipment until I can get my money out of it.”
Assume that income tax rates are 35% on ordinary income. The minimum desired rate of return, after taxes, is
12%.
QUESTIONS
1. Using the net present value approach, should the proposed equipment be purchased?
2. Comment on the reasoning of Ms. Miller.
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CAPITAL BUDGETING

Tan-talize, Inc.

(Sunk Costs)

On January 2nd, Tan-talize, Inc. installed a brand new special molding machine for producing a new line of

suntan products. The machine had a cash cost of $40,500 and is to be depreciated using the 3-year column of the

MACRS table. The machine has an expected life of four years and a disposal value of zero at the end of four

years.

On January 3rd, Art Taitt, a salesman for Los Angeles Machine Tool Company, called on Glynda Miller,

production manager of Tan-talize. During the course of their conversation, Mr. Taitt told Ms. Miller: “I wish I

had known earlier of your purchase plans. Our company can supply you with a technically superior machine for

$50,000. The old machine has a salvage value of $8,000 today. I can guarantee that our machine will save you

$17,000 per year in cash operating costs, although it too will have no disposal value at the end of four years.”

Mr. Taitt provided some technical data for Ms. Miller to examine. Although she had confidence in Mr. Taitt’s

data, Ms. Miller contended: “I’m locked into my previous decision. My alternatives are clear. Disposal will

result in a loss on the present machine. Moreover, keeping and using the present equipment avoids such a loss. I

have enough sense to avoid a loss when my only other alternative is to recognize a loss. I have to use the present

equipment until I can get my money out of it.”

Assume that income tax rates are 35% on ordinary income. The minimum desired rate of return, after taxes, is

QUESTIONS

  1. Using the net present value approach, should the proposed equipment be purchased?
  2. Comment on the reasoning of Ms. Miller.

CASH OUTFLOWS (OR INITIAL INVESTMENT)

Cost of New Asset $50,

Shipping 0

Working Capital 0

Sale Proceeds (8,000)

Tax on Sale of Old Asset (see below) (11,375)

Total Cash Outflows (Initial Investment) $30,

TAX ON SALE OF OLD MACHINE

Original Cost $40,500 Selling Price $8,

  • Acc. Depreciation 0 - Book Value 40,

Book Value $40,500 Gain (Loss) ($32,500)

Total Tax = Gain * Tax rate = ($32,500) x 35% = ($11,375)

CHANGE IN DEPRECIATION

Depreciation Depreciation Change in

on New Asset - on Old Asset = Depreciation

Next Year = $16,650 - $13,487 = $3,

Year 2 = 22,250 - 18,023 = 4,

Year 3 = 7,400 - 5,994 = 1,

Year 4 = 3,700 - 2,997 = 703

DETERMINATION OF CASH INFLOWS

Net Change in

Savings x (1 - T.R.) + Depreciation x Tax Rate = Cash Inflow

1 $17,000 x 0.65 + $3,164 x 0.35 = $12,

2 17,000 x 0.65 + 4,228 x 0.35 = 12,

3 17,000 x 0.65 + 1,406 x 0.35 = 11,

4 17,000 x 0.65 + 703 x 0.35 = 11,

There are no terminal cash flows associated with the new machine (i.e., salvage value is zero, therefore there is

no tax to be paid upon disposal, and there is no working capital requirement.).