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ACCT505 Part B Capital Budgeting Problem Johnnie & Sons Paints Inc. Data: Cost of new equipment Expected life of equipment in years Disposal value in 5 years Life productionnumber of cans Annual production or purchase needs Initial training costs Number of workers needed Annual hours to be worked per employee Earnings per hour for employees Annual health benefits per employee Other annual benefits per employee% of wages Cost of raw materials per can Other variable production costs per can Costs to purchase cansper can Required rate of return Tax rate $200,000 5 $40,000 5,000,000 1,000,000 0 3 2,300 $8.50 $1,500 18% $0.20 $0.10 $0.50 10% 35% Make Cost to produce Annual cost of direct material: Need of 1 million cans per year Annual cost of direct labor for new employees: Wages Health benefits Other benefits Total wages and benefits Other variable production costs Total annual production costs Annual cost to purchase cans Purchase $200,000 58,650 4,500 10,557 73,707 100,000 $373,707 $500,000 Part 1 Cash flows over the life of the project Item Annual cash savings Tax savings due to depreciation Before Tax Amount Tax Effect $126,293 32,000 After Tax Amount 0.65 $82,090 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 Less depreciation Before tax income Tax at 35% rate After tax income $126,293 32,000 94,293 33,003 $61,290 $61,290 / $200,000 = 30.65% Part 4 Net present value Item Cost of machine Cost of training Annual cash savings Tax savings due to depreciation Disposal value Net Present Value Before Tax Amount Year 0 0 1-5 1-5 5 Tax % -$200,000 0 $126,293 $32,000 $40,000 After Tax 10% PV Present Amount Factor Value -$200,000 1.000 -$200,000 0 1.000 0 0.65 82,090 3.791 311,205 0.35 11,200 3.791 42,459 40,000 0.621 24,840 $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. Item Cost of machine and training Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow Year 5 inflow Year After Tax Amount 0 $ (200,000) 1 $ 93,290 2 $ 93,290 3 $ 93,290 4 $ 93,290 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% ACCT505 Part B Capital Budgeting Problem Clark Paints Data: Cost of new equipment Expected life of equipment in years Disposal value in 5 years Life productionnumber of cans Annual production or purchase needs Initial training costs Number of workers needed Annual hours to be worked per employee Earnings per hour for employees Annual health benefits per employee Other annual benefits per employee% of wages Cost of raw materials per can Other variable production costs per can Costs to purchase cansper can Required rate of return Tax rate $200,000 5 $40,000 5,500,000 1,100,000 0 3 2,000 $12.00 $2,500 18% $0.25 $0.05 $0.45 12% 35% Make Cost to produce Annual cost of direct material: Need of 1,100,000 cans per year Annual cost of direct labor for new employees: Wages Health benefits Other benefits Total wages and benefits Other variable production costs Total annual production costs Annual cost to purchase cans Purchase $275,000 72,000 7,500 12,960 92,460 55,000 $422,460 $495,000 Part 1 Cash flows over the life of the project Item Annual cash savings Tax savings due to depreciation Before Tax Amount Tax Effect $72,540 32,000 After Tax Amount 0.65 $47,151 0.35 $11,200 Total annual cash flow $58,351 Part 2 Payback period $200,000 / $58351 = 3.43 years Part 3 Annual rate of return Accounting income as result of decreased costs Annual cash savings Less depreciation Before tax income Tax at 35% rate After tax income $72,540 32,000 40,540 14,189 $26,351 $26,351 / $200,000 = 13.18% Part 4 Net present value Item Cost of machine Cost of training Annual cash savings Tax savings due to depreciation Disposal value Net Present Value Before Tax Amount Year 0 1 2 3 4 5 Tax % -$200,000 0 $126,293 $32,000 $40,000 After Tax 10% PV Present Amount Factor Value -$200,000 1.000 -$200,000 58,351 0.893 $52,099 0.65 58,351 0.797 $46,517 0.35 58,351 0.712 $41,533 58,351 0.636 $37,083 98,351 0.567 $55,807 $33,039 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. Item Cost of machine and training Year 1 inflow Year 2 inflow Year 3 inflow Year 4 inflow Year 5 inflow Year After Tax Amount 0 $ (200,000) 1 $ 58,351 2 $ 58,351 3 $ 58,351 4 $ 58,351 5 $ 98,351 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 17.99% 17.99% Answer 2: Comment The Net Present Value of the project $33,039.37 is the Net Present Value of the project. It gives a positive indication so the project should be accepted. 17.99% is the internal rate of return of the project whereas the cost of capital is 12%. Since the internal rate of return is more than the cost of capital so the projet should be accepted. The present value of future cash inflows is more than the cost of investment. So the project should be accepted