Four Capital Budgeting Problems - Managerial Accounting | | Study notes Management Accounting

Additional Capital Budgeting Problems

For all problems, calculate the net present value of the project.

Problem 1

MicroTest Technology, Inc. is a high-technology company that manufactures

sophisticated testing instruments for evaluating microcircuits. These instruments sell for

$3,500 each and cost $2,450 each to manufacture. An essential component of the

company's manufacturing process is a sealed vacuum chamber whose interior approaches

a pure vacuum. The technology of the vacuum pumps that the firm uses to prepare its

chamber for sealing has been changing rapidly. On January 2, 20x0, MicroTest bought

the latest in electronic high-speed vacuum pumps, a machine that allowed the company to

evacuate a chamber for sealing in only six hours. The company paid $400,000 for the

pump. Recently, the manufacturer of the pump approached MicroTest with a new pump

that would reduce the evacuation time to two hours. MicroTest's management is

considering the acquisition of this new pump and has asked Melanie Harris, the controller,

to evaluate the financial impact of replacing the existing pump with the new model.

Harris has gathered the following information prior to preparing her analysis:

• The new pump would be installed on December 31, 20x2, and put in service on

January 1, 20x3. The cost of the pump is $608,000, and the costs for installing,

testing, and debugging the new pump will be $12,000. For depreciation purposes,

these costs will be considered part of the cost of the equipment. The pump is

expected to have a salvage value of $80,000 when sold at the end of four years.

• If the new pump is purchased, arrangements will be made to sell the old pump for

$50,000, the estimated salvage value on December 31, 20x2. The old pump has a

remaining useful life of 4 years and its salvage value at the end of 4 years is

$10,000

• At the current rate of production, the new pump's greater efficiency will result in

annual cash savings of $125,000.

• MicroTest is able to sell all of the testing instruments it can produce. Because of

the increased speed of the new pump, output is expected to be 30 units greater in

20x3 than in 20x2. In 20x4 and 20x5, production will be 50 units greater than in

20x2. The production in 20x6 will exceed 20x2 production by 70 units. For all

additional units produced, the manufacturing costs would be reduced by $150 per

unit.

• Working capital will increase by $80,000 for the duration of this project.

• For evaluating capital investment proposals, MicroTest's management uses a 16

percent after-tax discount rate.

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Additional Capital Budgeting Problems For all problems, calculate the net present value of the project. Problem 1 MicroTest Technology, Inc. is a high-technology company that manufactures sophisticated testing instruments for evaluating microcircuits. These instruments sell for $3,500 each and cost $2,450 each to manufacture. An essential component of the company's manufacturing process is a sealed vacuum chamber whose interior approaches a pure vacuum. The technology of the vacuum pumps that the firm uses to prepare its chamber for sealing has been changing rapidly. On January 2, 20x0, MicroTest bought the latest in electronic high-speed vacuum pumps, a machine that allowed the company to evacuate a chamber for sealing in only six hours. The company paid $400,000 for the pump. Recently, the manufacturer of the pump approached MicroTest with a new pump that would reduce the evacuation time to two hours. MicroTest's management is considering the acquisition of this new pump and has asked Melanie Harris, the controller, to evaluate the financial impact of replacing the existing pump with the new model. Harris has gathered the following information prior to preparing her analysis:

The new pump would be installed on December 31, 20x2, and put in service on January 1, 20x3. The cost of the pump is $608,000, and the costs for installing, testing, and debugging the new pump will be $12,000. For depreciation purposes, these costs will be considered part of the cost of the equipment. The pump is expected to have a salvage value of $80,000 when sold at the end of four years.
If the new pump is purchased, arrangements will be made to sell the old pump for $50,000, the estimated salvage value on December 31, 20x2. The old pump has a remaining useful life of 4 years and its salvage value at the end of 4 years is $10,
At the current rate of production, the new pump's greater efficiency will result in annual cash savings of $125,000.
MicroTest is able to sell all of the testing instruments it can produce. Because of the increased speed of the new pump, output is expected to be 30 units greater in 20x3 than in 20x2. In 20x4 and 20x5, production will be 50 units greater than in 20x2. The production in 20x6 will exceed 20x2 production by 70 units. For all additional units produced, the manufacturing costs would be reduced by $150 per unit.
Working capital will increase by $80,000 for the duration of this project.
For evaluating capital investment proposals, MicroTest's management uses a 16 percent after-tax discount rate.

Problem 2 Red Tomato Inc. must purchase an auto sorter to replace its existing one. This is an essential investment because manual sorting is too demanding and causes physical problems for employees. Two models that would adequately meet the company’s needs are available. Model A costs $45,000 and would reduce annual operating costs by $2,400. Model B costs $60,000 and would reduce annual operating costs by $4,000. Both models would have a useful life of 15 years and no salvage value at the end of their useful life. The company has a 12% cost of capital. The old auto sorter can be traded in now for either model for $7,600. Which Model should the company choose to replace the existing sorter? Problem 3 A company is considering buying a new machine for $1,200,000. The new machine will replace the current machine, which can be sold now for $75,000. The company will incur installation costs of $130,000 if it buys the new machine. The company’s cost of capital after tax is 12%. Buying the new machine would generate the following annual savings: Year 1 $130, Year 2 140, Year 3 150, Year 4 175, Year 5 180, Year 6 185, Year 7 195, If the company decides to keep the old machine for 7 more years, it will have to spend $45,000 in 3 years from now for a complete refurbishment. On the other hand, if the company decides to buy the new machine, it would have to spend $40,000 for maintenance in year 5. In 7 years, the salvage value of the new machine would be $120,000, and the salvage value for the old machine would be $30,000. The new machine will require a working capital investment of $50,000.

SOLUTIONS

Problem 1 Initial investment

new pump ($608, Purchase Price + 12, Installation - 50, Salvage – Old Pump ) ($570,000)
working capital (80,000) Present value of annual cash savings N = 4 I = 16 PMT = 125,000 349, Present value of additional sales: CM per unit sold = $3,500 Sales Price^ – 2,450 Cost to Manufacture^ + 150 Savings = $1, N = 1 I = 16 FV = 30 x $1,200 = 36,000 31, N = 2 I = 16 FV = 50 x $1,200 = 60,000 44, 590 N = 3 I = 16 FV = 50 x $1,200 = 60,000 38, N = 4 I = 16 FV = 70 x $1,200 = 84,000 46, Recovery at end of project N = 4 I = 16 FV = 80, Machine + 80, Working Capital
10, Salvage Value of Old Pump = $150,000 82, Net Present Value ($56,928) Recommend that the do not purchase the new pump. Problem 2 Given that the question states that we must replace the existing sorter, keeping it is therefore not an option. The salvage value now of the existing sorter is not relevant to the decision as they will be the sale regardless of the model we choose to replace it. The NPV analysis will compare Model B vs. Model A: Net Initial investment: $60,000 – 45,000 ($15,000) Present value of incremental savings: N = 15 I = 12 PMT = $4,000 – 2,400 = 1,600 10, Incremental NPV of Model B over Model A ($4,103) They should therefore purchase model A.

Problem 3 Initial investment

new machine ($1,200,000 + 130,000 Installation
- 75,000 Proceeds on Old Machine) $($1,255,000)
working capital (50,000) Present Value of annual cash flows: N = 1 I = 12 FV = $130,000 116, N = 2 I = 12 FV = $140,000 111, N = 3 I = 12 FV = $150,000 + 45,000 Saved Refurbishment^ –^ Old^ Machine^ 138, N = 4 I = 12 FV = $175,000 111, N = 5 I = 12 FV = $180,000 – 40, Maintenance – New Machine 79, N = 6 I = 12 FV = $185,000 93, N = 7 I = 12 FV = $195,000 88, Recovery at end of project N = 7 I = 12 FV = $120, New Machine - 30, Old Machine

50,000 Working Capital^ = 140,000 63, Net present value ($502,605) Recommend they do not purchase the new machine. Problem 4 Initial investment

machine ($116,000 – 7,000 Old Machine) ($109,000)
working capital (20,000) Present value of annual cash flows Variable costs = $1.00 + 1.30 + 0.80*0.4 = $2. Variable cost savings per unit = $2.62 x 20% = $0. Total variable cost savings = $0.524 x 100,000 = 52, N = 5 I = 15% PMT = 52,400 175, Recovery at end of project N = 5 I = 15% FV = 10,000 Salvage Value^ + 20,000 Working Capital = 30,000 14, Net Present Value $61, Recommend they purchase the new machine.

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SOLUTIONS