Mini Case #2: Capital Budgeting at Rio Negro, Inc.

Assignment Overview

Rio Negro, Inc. (RNI) is in the business of transporting cargo between ports in California and Washington. Its fleet

includes a small dry-cargo vessel, the Maracas. The Maracas is 25 years old and badly in need of an overhaul.

It is March 2016, and Michael John, the finance director, has just been presented with a proposal that would require

the one-time expenditures shown below in Table 1. If the proposal is accepted, these expenditures will be made in

the next few days. Mr. John believes that all these outlays could be depreciated for tax purposes in the seven-year

MACRS class (see Table 2 below for rates). Overhaul of the Maracas will begin as soon as the expenditures in

Table1 are made, but the vessel will be out of service for several months. The overhauled vessel would resume

commercial service in one year. RNI's chief engineer's estimates of the post-overhaul operating costs are in Table 3.

In addition to the overhaul described above, the chief engineer suggests installation of a brand- new engine and

control system. Installation of this new engine would cost an extra $600,000 (This additional outlay would also

qualify for tax depreciation in the seven-year MACRS class.). However, if the additional equipment is installed, it

would result in reduced fuel, labor, and maintenance costs as shown in Table 4.

The operating cost estimates in Tables 3 and 4 are current for March 2016. However, these costs will increase with

inflation, which is forecasted at 1.25% a year. Depreciation and operating costs attributable to the overhaul of

the Maracas will begin one year after the vessel is put back into commercial service. The revenues from operating

the vessel will be the same for both types of overhaul.

Even with the proposed overhaul, the Maracas cannot continue forever. After the overhaul, its remaining useful life

is estimated to be only 12 years. Its salvage value when finally taken out of service will be trivial. Thus, Mr. John

feels it is unwise to proceed without also considering the purchase of a new vessel. Racette & Sons (R&S), a

Colorado shipyard, has approached RNI with a design incorporating a Kort nozzle, extensively automated

navigation and power control systems, and much more comfortable accommodations for the crew. R&S is offering

the new vessel for a fixed price of $3,000,000, payable half immediately and half on delivery in one year. Estimated

annual operating costs of the new vessel are in Table 5. The operating cost estimates in the table are current for

March 2016, but will increase with inflation.

The crew would require additional training to handle the new vessel's more complex and sophisticated equipment.

Training would result in a one-time cost of $50,000 payable one year following delivery of the new vessel. This cost

is tax deductible.

The estimated operating costs for the new vessel assume that it would be operated in the same way as the Maracas.

However, the new vessel will be able to handle a larger load on some routes, which is expected to generate

additional revenues, net of additional operating costs, of approximately $175,000 per year in the first year of

operation. These revenues are expected to grow at the rate of inflation. Revenues and operating costs from the new

vessel will begin one year after it is delivered. The new vessel is estimated to have a useful service life of 20 years,

but it will be depreciated for tax purposes according to the 7-year MACRS schedule. The new vessel is not expected

to have any resale value at the end of its 20-year useful life. All revenues and costs (including depreciation)

associated with the new vessel will begin one year after it is delivered.

The Maracas is carried on RNI's books at a book value of only $100,000 and the book value of the spare parts is

$40,000. The Maracas could probably be sold now "as is," together with its extensive inventory of spare parts, for

$200,000.

Mr. John stepped out on the foredeck of the Maracas as she chugged down the Cook Inlet. "A rusty old tub," he

muttered, "but she's never let us down. I'll bet we could keep her going until next year while Racette & Sons are

building her replacement. We could use up the spare parts ($40,000) to keep her going and we should even be able

to sell or scrap her for book value when her replacement arrives."

RNI evaluates capital investments of this type using a 8.5% cost of capital. (This is a nominal, not real, rate.) RCI's

tax rate is 35%.

Table 1: Overhaul Expenditures

Overhaul engine and generators $340,000

Replace radar and other electronic equipment 75,000

Repairs to hull and superstructure 310,000

Painting and other repairs 95,000

$820,000

Table 2: Depreciation (in %) for the 7-year Modified Accelerated Cost Recovery System

Year 1 14.29

Year 2 24.49

Year 3 17.49

Year 4 12.49

Year 5 8.93

Year 6 8.93

Year 7 8.93

Year 8 4.45

Table 3: Post-overhaul Operating Costs (Basic Overhaul)

Fuel $450,000

Labor and benefits 480,000

Maintenance 141,000

Other 110,000

$1,181,000

Table 4: Post-overhaul Operating Costs (Overhaul plus new engine & control system)

Fuel $400,000

Labor and benefits 405,000

Maintenance 105,000

Other 110,000

$1,020,000

Table 5: Operating Costs of New Vessel

Fuel $380,000

Labor and benefits 330,000

Maintenance 70,000

Other 105,000

$885,000

Guidelines for Case Analysis

The following aids are permitted for this analysis: You may use internet sources, books, all posted materials

(including Discussion Board Q&A), and your notes.

Any other aids are unauthorized and their use constitutes a violation of academic integrity. This includes face-toface

or electronic correspondence concerning the specific details of the case with any other person that is not a

member of your assigned group, whether or not they have current or past affiliation with Texas A&M Corpus Christi

University.

The case is due on the date indicated on the course schedule. Late papers may be accepted with a reasonable excuse,

but will be assessed a 20% grade reduction penalty. Cases should be typed in 12- point font, double-spaced, with

a minimum of 1 inch margins.

The case report should be written according to the following format:

1. Introduction

2. Analysis

3. Conclusion

The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s)

or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a

direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or

numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis.

Your report should not exceed five pages of double-spaced text with 1 inch margins at the sides, top, and

bottom of the page. This does not include exhibits of your computations. You may submit one Excel Spreadsheet

that contains all your exhibits, clearly labeled, and appropriately referenced in the text of your report.

Your analysis of "Rio Negro, Inc." should consist of answers to the questions below. Do not write the questions

verbatim in your report. Instead, write a brief introductory statement that summarizes the question before you

proceed with your analysis.

4. Calculate the present value of the proposed overhaul of the Maracas, with and without the new engine and

control system. Should RNI do the basic overhaul or the expanded overhaul with the new engine and control

system? For the moment, ignore the option to purchase a new vessel (you will evaluate that option in question

2 below).

Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show

detailed computations in your Excel spreadsheet labeled Exhibit 1.

5. Calculate the present value of buying and operating the new vessel. What, if any, additional information

would be useful to you in your analysis?

Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show

detailed computations in your Excel spreadsheet labeled Exhibit 2.

6. Calculate the equivalent annual costs of (a) overhauling and operating the Maracas for 12 more years (with

and without the new engine and control system) and (b) buying and operating the proposed replacement vessel

for 20 years. You should use the real discount rate for this analysis. Based on your answer, what should RNI

do?

Write one to two paragraphs giving your answer and clearly explaining your reasoning and computations; show

detailed computations in your Excel spreadsheet labeled Exhibit 3.

7. Why is the equivalent annual cost method potentially useful in decision making in this case? Why would you use the

real discount rate to compute the EAC? What problem(s) do you see with using the equivalent annual cost method to

evaluate RNI's options?

One to two paragraphs.

Your report is intended for the senior management of Rio Negro, Inc., so be sure that you write in a

professional style that is easy to follow.