Self-Study Problem 12-1 (Algo) Capital Budgeting for Expanding Productive Capacity [LO 12-3, 12-4, 12- 5, 12-6] Ray Summers Company operates at full capacity of 12,058 units per year. The company, however, is still unable to fully meet the demand for its product, estimated at 15,000 units annually. This level of demand is expected to continue for at least another four years. To meet the demand, the firm is considering the purchase of new equipment for $580,000. This equipment has an estimated useful life of 4 years; estimated sales (disposal) value of this asset at the end of 4 years is $50,000 (pretax). The engineering division estimates that installing, testing, and training for the use of the equipment will cost $12,000. These costs are to be capitalized as part of the cost of the new equipment. An adjacent vacant warehouse can be leased for the duration of the project for $10,000 per year, which cost would be included as part of fixed manufacturing overhead. The warehouse needs $58,000 of renovations to make it suitable for manufacturing. The renovation cost is to be capitalized as part of the cost of the new equipment. The lease terms call for restoring the warehouse to its original condition at the end of the lease. The restoration is estimated to cost $20,000, a cost that is fully deductible for tax purposes. Current pretax operating profit per unit is as follows: Sales price Variable costs: Manufacturing Marketing Fixed costs: Manufacturing Marketing and administrative Operating profit before tax $ 102 34 $ 136 $ 25 15 Per Unit $ 340 40 176 $ 164 The new equipment would have no effect on the variable costs per unit. All current fixed costs are expected to continue with the same total amount. The per-unit fixed cost includes depreciation expenses of $5 for manufacturing and $4 for marketing and administration. Additional fixed manufacturing costs of $140,000 (excluding depreciation on the new equipment) will be incurred each year if the equipment is purchased. The company must also hire an additional marketing manager to serve new customers. The annual cost for the new marketing manager, support staff, and office expense is estimated at approximately $100,000. The company expects to be in the 40% tax bracket for each of the next 4 years. The company requires a minimum after-tax rate of return of 12% on investments and for tax purposes uses straight-line depreciation with a $50,000 salvage value assumed. (Use Table 1 and Table 2.) Required: 1. What is the required net initial investment outlay (year 0)? 2. (a) What is the projected increase in after-tax operating profit for each of the first 3 years if the new equipment is purchased? (Assume for each year that sales equals production.) (b) What is the projected year-4 increase in after-tax operating profit if the new equipment is purchased? (Round your answers to the nearest whole dollar amount.) 3. (a) If the new equipment is purchased, what is the projected increase in after-tax cash inflow for each of the first 3 years of the asset's life? (b) What is the projected year 4 increase in after-tax cash inflow if the new equipment is purchased? (Round your answers to the nearest whole dollar amount.) 4. Compute the (unadjusted) payback period of the proposed investment under the assumption that cash inflows occur evenly throughout the year. (Round your answer to 2 decimal places.) 5. Compute the accounting (book) rate of return (ARR) of the proposed investment, based on the average book value of the investment. (Round your answers to 2 decimal places. (i.e. 0.1234 = 12.34%).) 6. Compute the estimated net present value (NPV) of the proposed investment under the assumption that all cash inflows occur at year-end. (Round your answers to the nearest whole dollar amount.) 7. Compute the discounted payback period of the proposed investment under the assumption that cash inflows at the end of each year. (Round your answer to the nearest whole number.) 8. Compute the internal rate of return (IRR) of the proposed investment (to 1 decimal place) under the assumption that all cash inflows occur at year-end. (Round your answers to 1 decimal place. (i.e. 0.123 = 12.3%).) 9. Use the MIRR function in Excel to estimate the modified internal rate of return (MIRR) for the proposed investment. (Round your answers to 1 decimal place. (i.e. 0.123 = 12.3%).) 10. Assume now that the company expects the variable manufacturing cost per unit to increase once the new equipment is in place. What is the most that the per-unit variable manufacturing cost can increase and still allow the company to earn the minimum rate of return on this investment? (Hint: Use the Goal Seek option in Excel.) (Round your answer to 2 decimal places.) 1. Net initial investment outlay, year 0 2a. Incremental after-tax operating profit, years 1 through 3 2b. Incremental after-tax operating profit, year 4 3a. Incremental after-tax cash inflows, years 1 through 3 3b. Incremental after-tax cash inflows, year 4 Accounting rate of return (ARR) 4. Payback period 5. 6. Net present value (NPV) 7. Discounted payback period is slightly 8. Internal rate of return (IRR) 9. Modified internal rate of return (MIRR) 10. Variable manufacturing cost per unit can increase by $ 650,000 years % [less than years % %