Required Rate of Return

The CFO of Container Corporation has estimated the companys weighted average cost of capital. Based on her calculations, the appropriate required rate of return for this analysis is WACC = 10% per year.

Proposal #1

The first investment alternative to consider is the replacement of the packaging machine. The machine currently being used was purchased 5 years earlier for $30,000. At that time, the firm decided to depreciate the machine on a straight-line basis over 15 years, thus generating $2,000 in depreciation expense each year. At the end of its 15-year life, there is no anticipated salvage value. In other words, at that time, the old machine is expected to be worthless. At the present time, the old machine is contributing $17,500 annually to revenues while the operating expenses have been running $10,000 per year. It can be sold today for $7,500.

If a new replacement machine were purchased now, it would cost the company $35,000. The new machine would have a useful life of 10 years. At the end of its 10-year life, it could be sold for $7,500. The depreciation method would be MACRS 7-year. It is estimated that the new machine would contribute $25,000 to revenues each year, with annual operating costs of $8,000. For the investment analysis, a 21% tax rate would be appropriate.

Proposal #2

The second investment alternative is the purchase of a series of new machines that would greatly enhance the firms ability to enter the bubble packaging business. The total cost of this investment package would be $1 million. The machines would have a useful life of 10 years and would be depreciated using MACRS 7-year. It is anticipated that the new machines will generate annual sales (revenue) increases and operating expense increases as shown in Exhibit 1 below. The machines would require a net working capital investment of $62,500. At the end of their useful life, the machines are expected to be worthless and will generate no salvage value. As with the other investment opportunity, the appropriate tax rate is 21%

Assignment

The president of Container Corporation has assigned you to provide her with the following:

1. a worksheet showing initial, operating, and terminal cash flows for the replacement project analysis (proposal #1);

Exhibit 1.

Year Forecast Sales Forecast Operating

Increases Expense Increases

1 $ 250,000 $ 50,000

2 500,000 50,000

3 750,000 50,000

4 1,000,000 75,000

5 1,000,000 75,000

6 1,000,000 75,000

7 750,000 40,000

8 500,000 40,000

9 350,000 40,000

10 250,000 30,000

MACRS

ownership Class of Investment

year 3-year 5-year 7-year 10-year

1 33% 20% 14% 10%

2 45 32 25 18

3 15 19 17 14

4 7 12 13 12

5 11 9 9

6 6 9 7

7 9 7

8 4 7

9 7

10 6

11 3