Capital Budgeting Case In December of 20X1, Balloon Popper Inc. was trying to de

Question

Capital Budgeting Case

In December of 20X1, Balloon Popper Inc. was trying to decide whether to add a new line of super strong balloons to its product line. In order to do this, it would need to buy a new silicone pouring machine (cost below).

Sales for the new balloons were expected to be $2000000 per year from which sales commissions were to be paid to Balloon Poppers sales agents (see below).   Direct manufacturing costs were budgeted at $600,000 for materials, and $900,000 for labor. The new equipment would cost $600,000, and have a disposal value of $50,000.

Sales Commissions

5%

Economic life

5

Cost of Capital

7%

Initial Cost

1500000

Ignoring taxes, what is the IRR of the project? What is the NPV of the new project? Assume the machinery will be installed on January 1 of 20x1 and be depreciated using the straight line method. (it is easiest to calculate IRR using Excel)

Assuming a 40% tax rate, and that according to the IRS this is a 5 year asset (MACRS rates for Yr 1 .2, YR 2 .32, YR 3 .192, YR 4 .115, Y5 5 .115, YR 6 .058), what is the IRR? What is the NPV?

To stimulate industrial development, the tax rules allow 60% of the asset cost to be deducted the first year, with the remaining f the asset cost to be deducted equally over the remaining 4 years (since it is considered to be a 5 year asset). What is the IRR, What is the NPV?

If Baloon Popper requires a 12 % return on all new investments, should they take on this investment?

What is the payback period?

What is the accounting rate of return?

Do you believe you should invest in the project? Why?

Sales Commissions

5%

Economic life

5

Cost of Capital

7%

Initial Cost

1500000

Explanation / Answer

Computation of annual cash flows:

Total cash expenses = Direct materials + Direct labor + Sales Commissions = $ 600,000 + $ 900,000 + $ 100,000 = $ 1,600,000

Annual operating income before depreciation and tax = $ 2,000,000 - $ 1,600,000 = $ 400,000

Using Excel, IRR = 42%

Present value of cash inflows = 372,000 x 0.893 + 262,000 x 2.145 + 312,000 x 0.567 = 332,196 + 561,990 + 176,904 = $ 1,071,090

NPV at 12% = 1,071,090 - 600,000 = $ 471,090

Accounting rate of return = (400,000 - ( 550,000 /5)) / 600,000 x 100 = 48.33%

Payback period = 600,000 / 294,000 = 2.04 years

Year 0 1 2 3 4 5 Annual operating income before depreciation and tax 0 400,000 400,000 400,000 400,000 400,000 Depreciation for tax purposes 0 330,000 55,000 55,000 55,000 55,000 Income before taxes 70,000 345,000 345,000 345,000 345,000 Income after tax 42,000 207,000 207,000 207,000 207,000 Cash flows ( 600,000) 372,000 262,000 262,000 262,000 312,000

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