Capital budgeting with taxes and strategic consideration Ronnie's Welding uses welding equipment mounted in the bed of a pickup truck to provide on-site welding services. The expected life of his existing equipment is five more years, after which the equipment will be worthless and scrapped for zero salvage.

Ronnie is considering replacing his existing welding equipment. The new equipment will allow him to do jobs that he must now decline and also reduce the costs of his current jobs. The new equipment should last five years, reduce the operating costs associated with existing jobs by $9000 per year, and attract new jobs that will provide incremental profits of $5000 per year. The purchase price of the new equipment is $50,000, net of what Ronnie could get from sell¬ ing his old equipment. The salvage value of the new equipment would be $2000 in five years. Assume that Ronnie can borrow money at 12% and that he faces a 40% marginal tax rate. Assume that for tax purposes Ronnie will depreciate the net investment (that is, purchase price less salvage value) on a straight-line basis.

(a) Using the net present value criterion, is this investment desirable?

(b) Suppose that while he is considering this project, Ronnie discovers that the quality of the welds produced by the new machine exceeds the quality of the welds made by the old machine. Because weld quality is related to safety, Ronnie knows that this will be attractive to many of his customers. Suppose that Ronnie believes that if he buys the machine and his competi¬ tors do not, the increased profits associated with the new machine will be $8000 instead of the original estimate of $5000. Is this investment desirable?

(c)Ronnie knows that his competitors have access to the same trade informa¬ tion that he does and that he cannot restrict their access to the equipment that he is considering. What do you think would happen if all these competi¬ tors purchased the equipment? What do you think would happen if only one competitor purchased the equipment?

LO 3, 4