ACCT505
Part B
Capital Budgeting Problem
Johnnie & Sons Paints Inc.
Data:
Cost of new equipment
$200,000
Expected life of equipment in years
5
Disposal value in 5 years
$40,000
Life production—number of cans
5,000,000
Annual production or purchase needs
1,000,000
Initial training costs
0
Number of workers needed
3
Annual hours to be worked per employee
2,300
Earnings per hour for employees
$8.50
Annual health benefits per employee
$1,500
Other annual benefits per employee—% of wages
18%
Cost of raw materials per can
$0.20
Other variable production costs per can
$0.10
Costs to purchase cans—per can
$0.50
Required rate of return
10%
Tax rate
35%
Make
Purchase
Cost to
produce
Annual cost of direct material:
Need of 1 million cans per year
$200,000
Annual cost of direct labor for new
employees:
Wages
58,650
Health benefits
4,500
Other benefits
10,557
Total wages and benefits
73,707
Other variable production costs
100,000
Total annual production costs
$373,707
Annual cost to purchase cans
$500,000
Part
1 Cash flows over the life of the project
Before Tax
Tax
After Tax
Item
Amount
Effect
Amount
Annual cash savings
$126,293
0.65
$82,090
Tax savings due to depreciation
32,000
0.35
$11,200
Total annual cash flow
$93,290
Part
2 Payback period
$200,000 / $93290 =
2.14
years
Part
3 Annual rate of return
Accounting income as result of
decreased costs
Annual cash savings
$126,293
Less depreciation
32,000
Before tax income
94,293
Tax at 35% rate
33,003
After tax income
$61,290
$61,290 / $200,000 =
30.65%
Part
4 Net present value
Before Tax
After Tax
10% PV
Present
Item
Year
Amount
Tax %
Amount
Factor
Value
Cost of machine
0
-$200,000
-$200,000
1.000
-$200,000
Cost of training
0
0
0
1.000
0
Annual cash savings
1-5
$126,293
0.65
82,090
3.791
311,205
Tax savings due to depreciation
1-5
$32,000
0.35
11,200
3.791
42,459
Disposal value
5
$40,000
40,000
0.621
24,840
Net Present Value
$178,504
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
$ (200,000)
Year 1 inflow
1
$ 93,290
Year 2 inflow
2
$ 93,290
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