Capital Budgeting Decision Hampton Company: The production department has been i

Question

Capital Budgeting Decision

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 calculate the following items for this proposed equipment purchase.

o Annual cash flows over the expected life of the equipment

o Payback period o Simple rate of return

o Net present value o 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?

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Explanation / Answer

Step 1) initial investment = $1,000,000

Step 2) Depreciation= No. of unit produced/life in number of unit * (cost-salvage value)

=5500,000/27500000 * (1000000-200000)

0.2*800,000

=160,000 Every year

Step 3) Statement showing NPV

Pay back period = 1000000/277650 = 3.6 years

Return = 277560/1000000= 27.765%

IRR is the rate at which NPV is 0, Thus IRR is 16.17166%

Since NPV is positive project should be accepted

Particulars 1 2 3 4 5 Total Savings per unit 0.5 0.5 0.5 0.5 0.5 Raw material cost per can 0.3 0.3 0.3 0.3 0.3 Other variable cost 0.1 0.1 0.1 0.1 0.1 Contribution per unit 0.1 0.1 0.1 0.1 0.1 total no of units 5500000 5500000 5500000 5500000 5500000 Total contribution 550000 550000 550000 550000 550000 Less: Employee cost(6*2000*15) 180000 180000 180000 180000 180000 Employee benefits(15% of wages) 27000 27000 27000 27000 27000 Health benefits 2000 2000 2000 2000 2000 Depreciation 160000 160000 160000 160000 160000 PBT 181000 181000 181000 181000 181000 Less: tax 35% 63350 63350 63350 63350 63350 PAT 117650 117650 117650 117650 117650 Add: depreciation 160000 160000 160000 160000 160000 Annual cash flow 277650 277650 277650 277650 277650 salvage value 200000 Total cash flow 277650 277650 277650 277650 477650 PVIF @ 11% 0.9009 0.8116 0.7312 0.6587 0.5935 PV 250135.1 225346.969 203015.287 182896.655 283462.027 1144856 Less: initial investment 1000000 NPV 144856

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