PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 2,6] Van Doren Corpora
ID: 2426520 • Letter: P
Question
PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 2,6] Van Doren Corporation is considering producing a new temperature regulator called Digidial.Marketing data indicate that the company will be able to sell 45,000 units per year at $30.The product will be produced in a section of an existing factory that is currently not in use.
To produce Digidial,Van Doren must buy a machine that costs $500,000.The machine has an expected life of six years and will have an ending residual value of $15,000.Van Doren will depreciate the machine over six years using the straight-line method for both tax and nancial reporting purposes.
In addition to the cost of the machine,the company will incur incremental manufacturing costs of $370,000 for component parts,$425,000 for direct labor,and $200,000 of miscellaneous costs.Also,the company plans to spend $150,000 annually to advertise Digidial.Van Doren has a tax rate of 40 percent,and the company’s required rate of return is 15 percent.
Required
a. Compute the net present value.
b. Compute the payback period.
c. Compute the accounting rate of return.
d. Should Van Doren make the investment required to produce Digidial?
Explanation / Answer
Year
Given
0
1
2
3
4
5
6
Total PV income
Expected no.of units of new products to be sold
45000
Selling Price of each unit
30
Total Sales Income ( Inflow )
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
Less Tax @ 40% charged
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
Sales Income after tax
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
Residual Value
$ -
$ -
$ -
$ -
$ -
$ -
$ 15,000
Less Tax @ 40% charged
$ -
$ -
$ -
$ -
$ -
$ -
$ 6,000
Total Income
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 816,000
Present Value Factors @ 15%
1
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
Present Value
$ 810,000
$ 704,376
$ 612,441
$ 532,575
$ 463,158
$ 402,732
$ 352,757
$ 3,878,039
Cost Incurred to manufacture new product ( Incrimental )
Purchase of New machine
$ 500,000
$ -
$ -
$ -
$ -
$ -
$ -
Less Tax @ 40% savings on Depreciation
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
Incrimental Manufacturing costs
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
Less Tax @ 40% savings on Manufacturing expenses
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
Direct Labour Costs
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
Less Tax @ 40% savings on direct labour expenses
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
Misc Costs
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
Less Tax @ 40% savings on Misc costs
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
Advertising Costs
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
Less Tax @ 40% savings on Advertising costs
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
Total Outflow
$ 1,154,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
Present Value Factors @ 15%
1
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
Present Value
$ 1,154,667
$ 569,298
$ 494,993
$ 430,443
$ 374,338
$ 325,500
$ 283,012
$ 3,632,253
Net Present Value ( Inflow - Outflow )
$ 245,786
Accounting Rate of Return ( Average accounting profit /Average Investment )
Accounting Profit
$ (344,667)
$ 135,078
$ 117,448
$ 102,132
$ 88,820
$ 77,232
$ 69,744
Average Accounting Profit for 6 years
$ 40,964
Average Investment
$ 500,000
Accounting Rate of Return ( Average accounting profit /Average Investment )
8%
Total Cash flow
$ (344,667)
$ 135,078
$ 117,448
$ 102,132
$ 88,820
$ 77,232
$ 69,744
Cumilative cash flows
$ -
$ (209,589)
$ (92,141)
$ 9,990
$ 98,810
$ 176,042
$ 245,786
Payback Period
2 years + ( 92141.3/102131.7 )
2.902
3 Years Approx Payback Period
Conclusion
Since NPV is positive the new project should be produced, however since Accounting rate of return is less than required rate of return some may not desire to produce the new product
Depreciation calculated through SLM Method - (Cost – Residual Value)/Useful life
Year
Given
0
1
2
3
4
5
6
Total PV income
Expected no.of units of new products to be sold
45000
Selling Price of each unit
30
Total Sales Income ( Inflow )
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
$ 1,350,000
Less Tax @ 40% charged
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
$ 540,000
Sales Income after tax
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
Residual Value
$ -
$ -
$ -
$ -
$ -
$ -
$ 15,000
Less Tax @ 40% charged
$ -
$ -
$ -
$ -
$ -
$ -
$ 6,000
Total Income
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 810,000
$ 816,000
Present Value Factors @ 15%
1
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
Present Value
$ 810,000
$ 704,376
$ 612,441
$ 532,575
$ 463,158
$ 402,732
$ 352,757
$ 3,878,039
Cost Incurred to manufacture new product ( Incrimental )
Purchase of New machine
$ 500,000
$ -
$ -
$ -
$ -
$ -
$ -
Less Tax @ 40% savings on Depreciation
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
$ (32,333)
Incrimental Manufacturing costs
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
$ 370,000
Less Tax @ 40% savings on Manufacturing expenses
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
$ (148,000)
Direct Labour Costs
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
$ 425,000
Less Tax @ 40% savings on direct labour expenses
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
$ (170,000)
Misc Costs
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
$ 200,000
Less Tax @ 40% savings on Misc costs
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
$ (80,000)
Advertising Costs
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
$ 150,000
Less Tax @ 40% savings on Advertising costs
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
$ (60,000)
Total Outflow
$ 1,154,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
$ 654,667
Present Value Factors @ 15%
1
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
Present Value
$ 1,154,667
$ 569,298
$ 494,993
$ 430,443
$ 374,338
$ 325,500
$ 283,012
$ 3,632,253
Net Present Value ( Inflow - Outflow )
$ 245,786
Accounting Rate of Return ( Average accounting profit /Average Investment )
Accounting Profit
$ (344,667)
$ 135,078
$ 117,448
$ 102,132
$ 88,820
$ 77,232
$ 69,744
Average Accounting Profit for 6 years
$ 40,964
Average Investment
$ 500,000
Accounting Rate of Return ( Average accounting profit /Average Investment )
8%
Total Cash flow
$ (344,667)
$ 135,078
$ 117,448
$ 102,132
$ 88,820
$ 77,232
$ 69,744
Cumilative cash flows
$ -
$ (209,589)
$ (92,141)
$ 9,990
$ 98,810
$ 176,042
$ 245,786
Payback Period
2 years + ( 92141.3/102131.7 )
2.902
3 Years Approx Payback Period
Conclusion
Since NPV is positive the new project should be produced, however since Accounting rate of return is less than required rate of return some may not desire to produce the new product
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