| | ACCT505 | | | |
| | Project 2 | | | |
| | Sample Capital Budgeting Problem Solution | | | |
| | This file can be used as
the template for the actual project. | | |
| | | | | |
| | | 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 after-tax annual cash flow | | | $93,290 |
| | | | | |
| | | | | |
| Part
2 Payback Period | | | |
| | | | | |
| | $200,000 / $93290 = | 2.14 | years | |
| | | | | |
| | | | | |
| Part
3 Simple 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 | |
| | Item | Year | Amount | Tax % |
| | Cost of machine | 0 | -$200,000 | |
| | Cost of training | 0 | 0 | |
| | Annual cash savings | 1-5 | $126,293 | 0.65 |
| | Tax savings due to depreciation | 1-5 | $32,000 | 0.35 |
| | Disposal value | 5 | $40,000 | |
| | | | | |
| | Net Present Value | | | |
| | | | | |
| 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 |
| | | Year 3 inflow | 3 | $ 93,290 |
| | | Year 4 inflow | 4 | $ 93,290 |
| | | Year 5 inflow | 5 | $ 133,290 |
| | | | | |
| | | The IRR function will
require the range of cash flows, beginning with the initial cash outflow for
the investment |
| | | and progressing through
each year of the project. You also have to include an initial guess for the |
| | | possible IRR. The formula is: =IRR(values,guess) | |
| | | | | |
| | | IRR Function | IRR(f84..f89,.30) | 39.2% |
