Capital Budgeting Decision Here is Project 2: Hampton Company: The production de

Question

Capital Budgeting Decision

Here is Project 2:

Hampton Company: The production department has been investigating possible ways to trim total production costs. One possibility currently being examined is to make the cans instead of purchasing them. The equipment needed would cost $1,000,000, with a disposal value of $200,000, and would be able to produce 27,500,000 cans over the life of the machinery. The production department estimates that approximately 5,500,000 cans would be needed for each of the next 5 years.

The company would hire six new employees. These six individuals would be full-time employees working 2,000 hours per year and earning $15.00 per hour. They would also receive the same benefits as other production employees, 15% of wages in addition to $2,000 of health benefits.

It is estimated that the raw materials will cost 30¢ per can and that other variable costs would be 10¢ per can. Because there is currently unused space in the factory, no additional fixed costs would be incurred if this proposal is accepted.

It is expected that cans would cost 50¢ each if purchased from the current supplier. The company's minimum rate of return (hurdle rate) has been determined to be 11% for all new projects, and the current tax rate of 35% is anticipated to remain unchanged. The pricing for the company’s products as well as number of units sold will not be affected by this decision. The unit-of-production depreciation method would be used if the new equipment is purchased.

Required:

1. Based on the above information and using Excel, calculate the following items for this proposed equipment purchase.

Annual cash flows over the expected life of the equipment

Payback period

Simple rate of return

Net present value

Internal rate of return

The check figure for the total annual after-tax cash flows is $271,150.

2. Would you recommend the acceptance of this proposal? Why or why not? Prepare a short, double-spaced paper in MS Word elaborating on and supporting your answer.

ACCT505 Project 2 Data: Cost of new equipment Expected life of equipment in years Disposal value in 5 years Life production—number of cans Annual production or purchase needs Initial training costs Number of workers needed Annual hours to be worked per employee Earnings per hour for employees Annual health benefits per employee Other annual benefits per employee—% of wages Cost of raw materials per can Other variable production costs per can Costs to purchase cans—per can Required rate of return Tax rate Make Purchase Cost to Produce Annual cost of direct material: Need of 1 million cans per year Annual cost of direct labor for new employees: Wages Health benefits Other benefits     Total wages and benefits Other variable production costs Total annual production costs Annual cost to purchase cans Part 1 Cash Flows Over the Life of the Project Before Tax Tax After Tax Item Amount Effect Amount Annual cash savings Tax savings due to depreciation Total after-tax annual cash flow Part 2 Payback Period Part 3 Simple Rate of Return Accounting income as result of decreased costs Annual cash savings Less depreciation Before tax income Tax at 35% rate After tax income Part 4 Net Present Value Before Tax After Tax 10% PV Present Item Year Amount Tax % Amount Factor Value Cost of machine Cost of training Annual cash savings Tax savings due to depreciation Disposal value Net Present Value Part 5 Internal Rate of Return Excel function method to calculate IRR This function requires that you have only one cash flow per period (Period 0 through Period 5, for our example). This means that no annuity figures can be used. The chart for our example can be revised as follows. After Tax Item Year Amount Cost of machine and training 0 Year 1 inflow 1 Year 2 inflow 2 Year 3 inflow 3 Year 4 inflow 4 Year 5 inflow 5

Explanation / Answer

basic calculations amouts in dollars Cost of new equipment 1000000 Expected life of equipment in years 5 Disposal value in 5 years 200000 Life production—number of cans 27500000 Annual production or purchase needs 5500000 Initial training costs Number of workers needed 6 Annual hours to be worked per employee 2000 Earnings per hour for employees 15 30000 Annual health benefits per employee 2000 Cost of raw materials per can 0.3 Other variable production costs per can 0.1 Costs to purchase cans—per can 0.5 calculation of cash savings per year particulars amount number of units produced 5500000 purchase cost 5500000*0.30 1650000 variable cost 5500000*0.10 550000 wages 6*2000*15 180000 health benefits 2000 other benefits 180000*15% 27000 total production cost 2409000 total cost to purchase the material 5500000*0.50 2750000 savings in costs 2750000-2409000 341000 calculation of depreciation year amount 1 (1000000-200000)*5500000/27500000 160000 2 (1000000-200000)*5500000/27500000 160000 3 (1000000-200000)*5500000/27500000 160000 4 (1000000-200000)*5500000/27500000 160000 5 (1000000-200000)*5500000/27500000 160000 1 cash flows over the life of the project savings in costs before tax 341000 tax amount 35 % 119350 savings in costs after tax 221650 add - tax benefit on depreciation 160000*35% 56000 net savings per year 277650 2 payback period year 0 1 2 3 4 5 cash flows -1000000 277650 277650 277650 277650 277650 cumulative cash flows -1000000 -722350 -444700 -167050 110600 388250 payback period payback period is No. of years before first positive cumulative cash flow + (Absolute value of last negative cumulative cash flow / Cash flow in the year of first positive cumulative cash flow) 3 + (167050/277650) 3 + 0.60 3.6 3 calculationof simple rate of return Accounting income as result of decreased costs Annual cash savings 341000 Less depreciation 160000 Before tax income 181000 Tax at 35% rate 63350 After tax income 117650 rate of return 117650/1000000 rate of return 11.77% 4 calculation of net present value year 1 2 3 4 5 cash flows 277650 277650 277650 277650 477650 present rate factor at 11 % 0.900900901 0.811622433 0.73119 0.65873 0.59345 present value cash flows 250135.1351 225346.9686 203015 182897 283462 total present value cash flows 1144856 intial investment 1000000 net present value 144856 cash flows of 5th year 277650 + salvage value of the investment cash flows of 5th year 277650 + 200000 cash flows of 5th year 477650 5 calculation of internal rate of return year 0 1 2 3 4 5 cash flows -1000000 277650 277650 277650 277650 277650 .=irr(cashflows from year 0 to year 5 ) irr 12.03% basic calculations amouts in dollars Cost of new equipment 1000000 Expected life of equipment in years 5 Disposal value in 5 years 200000 Life production—number of cans 27500000 Annual production or purchase needs 5500000 Initial training costs Number of workers needed 6 Annual hours to be worked per employee 2000 Earnings per hour for employees 15 30000 Annual health benefits per employee 2000 Cost of raw materials per can 0.3 Other variable production costs per can 0.1 Costs to purchase cans—per can 0.5 calculation of cash savings per year particulars amount number of units produced 5500000 purchase cost 5500000*0.30 1650000 variable cost 5500000*0.10 550000 wages 6*2000*15 180000 health benefits 2000 other benefits 180000*15% 27000 total production cost 2409000 total cost to purchase the material 5500000*0.50 2750000 savings in costs 2750000-2409000 341000 calculation of depreciation year amount 1 (1000000-200000)*5500000/27500000 160000 2 (1000000-200000)*5500000/27500000 160000 3 (1000000-200000)*5500000/27500000 160000 4 (1000000-200000)*5500000/27500000 160000 5 (1000000-200000)*5500000/27500000 160000 1 cash flows over the life of the project savings in costs before tax 341000 tax amount 35 % 119350 savings in costs after tax 221650 add - tax benefit on depreciation 160000*35% 56000 net savings per year 277650 2 payback period year 0 1 2 3 4 5 cash flows -1000000 277650 277650 277650 277650 277650 cumulative cash flows -1000000 -722350 -444700 -167050 110600 388250 payback period payback period is No. of years before first positive cumulative cash flow + (Absolute value of last negative cumulative cash flow / Cash flow in the year of first positive cumulative cash flow) 3 + (167050/277650) 3 + 0.60 3.6 3 calculationof simple rate of return Accounting income as result of decreased costs Annual cash savings 341000 Less depreciation 160000 Before tax income 181000 Tax at 35% rate 63350 After tax income 117650 rate of return 117650/1000000 rate of return 11.77% 4 calculation of net present value year 1 2 3 4 5 cash flows 277650 277650 277650 277650 477650 present rate factor at 11 % 0.900900901 0.811622433 0.73119 0.65873 0.59345 present value cash flows 250135.1351 225346.9686 203015 182897 283462 total present value cash flows 1144856 intial investment 1000000 net present value 144856 cash flows of 5th year 277650 + salvage value of the investment cash flows of 5th year 277650 + 200000 cash flows of 5th year 477650 5 calculation of internal rate of return year 0 1 2 3 4 5 cash flows -1000000 277650 277650 277650 277650 277650 .=irr(cashflows from year 0 to year 5 ) irr 12.03%

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