Capital Budgeting The Hunter Company makes cookies for its chain of snack food s
ID: 2746036 • Letter: C
Question
Capital Budgeting
The Hunter Company makes cookies for its chain of snack food stores. On January 1, 2013 the Company purchased a special cookie cutting machine and has used this machine for the three-year period ending December 31, 2015. On January 1, 2016 Hunter is considered the purchase of a newer, more efficient, machine. If purchased, the new machine would be put into operation immediately (January 1, 2016). Either machine could be used for the next four years (2016, 2017, 2018, 2019)
Hunter expects to sell 300,000 dozen cookies in each of the next 4 years at an average price of $1.25 per dozen.
Hunter gives you the following information:
Old
Machine
New
Machine
Original cost at date of acquisition
$140,000
$200,000
Useful life from the date of acquisition
7 years
4 years
Expected cash operating expenses:
Variable cost per dozen cookies
$.40 per dozen
$.30 per dozen
Total fixed costs per year
$25,000
$20,000
Estimated cash value of machines:
January 1, 2016
$60,000
December 31, 2019
$0
$50,000
Annual Depreciation expense (under the straight-line method)
$20,000
$50,000
Hunter uses straight line depreciation for tax reporting purposes. The Company is subject to a marginal tax rate of 30 percent and has an after tax WACC of 14 percent.
Required:
1. Prepare a schedule showing the following relevant cash flows if Hunter purchases this investment.
a. Initial outflow if purchase the new machine and sell the old machine (at January 1, 2016).
b. Annual operating cash flows for each of the fours year period 2016, 2017, 2018, & 2019.
c. Residual (salvage) cash flow at December 31, 2019 upon the sale of the new machine.
2. Calculate the NPV if Hunter purchases the new machine.
3. Calculate the IRR if Hunter purchases the new machine.
4. Should Hunter purchase the new machine?
Old
Machine
New
Machine
Original cost at date of acquisition
$140,000
$200,000
Useful life from the date of acquisition
7 years
4 years
Expected cash operating expenses:
Variable cost per dozen cookies
$.40 per dozen
$.30 per dozen
Total fixed costs per year
$25,000
$20,000
Estimated cash value of machines:
January 1, 2016
$60,000
December 31, 2019
$0
$50,000
Annual Depreciation expense (under the straight-line method)
$20,000
$50,000
Explanation / Answer
1-a) INITIAL CASH OUTFLOW: cost of the new machine 200000 sale value of the old machine -60000 tax shield - 30% on the loss of $20000 -6000 Initial cash outflow on replacement 134000 1-b) ANNUAL OPERATING CASH FLOWS: 1 2 3 4 INCREMENTAL ANNUAL OPERATING CASH FLOWS: 33500 33500 33500 33500 (New -Old) Calculations given below: For old machine sales (300000*$1.25) 375000 375000 375000 375000 Less: variable cost (300000*0.40) 120000 120000 120000 120000 fixed cost 25000 25000 25000 25000 depreciation 20000 20000 20000 20000 operating profit 210000 210000 210000 210000 less: tax @ 30% 63000 63000 63000 63000 Operating profit after tax 147000 147000 147000 147000 add: depreciation 20000 20000 20000 20000 annual operating cash inflows from old machine 167000 167000 167000 167000 For new machine: sales (300000*$1.25) 375000 375000 375000 375000 Less: variable cost (300000*0.30) 90000 90000 90000 90000 fixed cost 20000 20000 20000 20000 depreciation 50000 50000 50000 50000 operating profit 215000 215000 215000 215000 less: tax @ 30% 64500 64500 64500 64500 Operating profit after tax 150500 150500 150500 150500 add: depreciation 50000 50000 50000 50000 annual operating cash inflows from old machine 200500 200500 200500 200500 1-c) RESIDUAL CASH FLOW: sale value of new machine 50000 tax @ 30% on gain of 50000 -15000 35000 2) NPV: annual operating cash inflows on replacement 33500 33500 33500 33500 pvif @ 14% 0.87719 0.76947 0.67497 0.59208 PV at 14% 29386 25777 22612 19835 Total PV of operating cash inflows 97609 PV of terminal cash inflow - 35000*.59208 20723 PV of cash inflows from the project 118332 Less: Initial cost 134000 NPV -15668 3) IRR: annual operating cash inflows on replacement 33500 33500 33500 33500 terminal cash inflow 35000 annual cash inflows from the project 33500 33500 33500 68500 pvif @ 8% 0.92593 0.85734 0.79383 0.73503 PV 31018.5 28720.9 26593.4 50349.5 pvif @ 9% 0.91743 0.84168 0.77218 0.70843 PV 30734 28196 25868 48527 IRR = 8 + (2682/(136682-133325) = 8.80% 4) The new machine should not be purchased as the NPV is negative and IRR of 8.8%Related Questions
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