Example: Capital Rationing

Mayco has a $$2,000$ capital budget and has the opportunity to invest in five different projects. The initial investment and NPV of the projects arc described in the following figure. Determine in which projects Mayco should invest.

Investment Outlay NPV

project A $-1200500$

project B $-1000480$

project C $-800300$

project D $-450150$

project E $-20040$

Example: Expansion Project analysis:

Mayco, Inc. would like to set up a new plant $($expand$).$ Currently, Mayco has an option to buy an existing building at a cost of $$24,000.$ Necessary equipment for the plant will cost $$16,000,$ including installation costs. The equipment falls into a MACRS $5-$year class. The building falls into a MACRS $39-$year class. The project would also require an initial investment of $$12,000$ in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment.

The project$$s estimated economic life is four years. At the end of that time, the building is expected to have a market value of $$15,000$ and a book value of $$21,816,$ whereas the equipment is expected to have a market value of $$4,000$ and a book value of $$2,720.$

Annual sales will be $$80,000.$ The production department has estimated that variable manufacturing costs will total $60\%$ of sales and that fixed overhead costs, excluding depreciation, will be $$10,000$ a year $[$costs: $(0\mathrm{.}60)80,000+10,000=58,000].$ Depreciation expense will be determined for the year in accordance with the MACRS rate.

Mayco$$s marginal federal$-$plus$-$state tax rate is $40\%$; its cost of capital is $12\%$; and, for capital budgeting purposes, the company$$s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.

Under MACRS, the pre$-$tax depreciation for the building and equipment is:

Year$1=$ $$3,512$ Year$2=$ $$5,744$ Year$3=$ $$3,664$ Year$4=$ $$2,544$

Compute the initial investment outlay, operating cash flow over the project$$s life, and the terminal$-$year cash flow for Mayco$$s expansion project. Then determine whether the project should be accepted using NPV analysis.

Example: Replacement project analysis

Suppose Mayea wants to replace an existing printer with a new high$-$speed copier. The existing printer was purchased ten years ago at a cost of$$15,000.$ The printer is being depreciated using straight line basis assuming a uscfullifi: of I $5$ years and no salvage value $($i$.$e$.,$ its annual depreciation is $I,OOO$).$ Currently, the printer has a net book value of $$5,000.$

The new high$-$speed copier can be purchased for $$24,000($including freight and installation$).$ Over its $5-$year life, it will reduce labor and raw materials usage sufficiently to cut annual operating costs from $I$4,000$ to $$8,000.$ This reduction in costs will cause before$-$tax profits to rise by $I$4,000-$ $$8,000=$ $$6,000$ per year.

It is estimated that the new copier can be sold for $$4,000$ at the end of five years; this is its estimarcd salvage value. The old printer's current market value is $$2,000,$ which is below its $$5,000$ book value. If the new copier is acquired, the old printer will be sold to another company.

The company's marginal federal$-$plus$-$state tax rate is $40\%,$ and the replacement copier is of slightly below$-$average risk. Net working capital requirements will also increase by $$3,000$ at the time of replacement. By an IRS ruling, the new copier falls into the $3-$year MACRS class. The project's cost of capital is set at $11\mathrm{.}5\%.$

Under the MACRS system, the pre$-$tax depreciation for the equipment is:

Year $1=$ $$7,920$; Year $2=$ $$10,800$; Year $3=$ $$3,600$; Year$4=$ $$1,680$; Year $5=$ $$0$

Compute the initial investment outlay, operating cash flow over the project's life, and the terminal$-$yeat cash flows for Mayco's replacement project. Then determine whether the project should be accepted using NPV analysis.