CAPITAL BUDGETING
Tan-talize Suntan Products
The president of Tan-talize Suntan Products 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 five 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 bya manufacturer called
ValuePlus. ValuePlus 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 $57,000, require modifications
costing $10,000, and also will require $2,000 in working capital to support the new equipment’s
operation. The equipment will be depreciated over a 5-year period and will have a total salvage
value of $4,000 at the end of the expected economic life of six years. The company will not deduct
the salvage value when calculating depreciation.
The annual savings are expected to be as follows:
Year Number 1 $15,000
Year Number 2 14,000
Year Number 3 13,000
Year Number 4 12,000
Year Number 5 11,000
Year Number 6 10,000
The old equipment can be sold for $3,000. It is now five years old and originallycost $40,000.
The company has been depreciating this equipment on a five-year MACRS basis also.
The firm has a hurdle rate of 8% for all potential projects and has a marginal tax rate of 25%.
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) profitability index, (3) internal rate of return, and
(4) payback period of the proposed project.
