Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 56

Comparison of Capital-Budgeting Techniques, Sensitivity Analysis Nil Hill Corporation has been using its present facilities at its annual full capacity of 10,000 units for the last three years. Still, the company is unable to keep pace with continuing demand for the product that is estimated to be 25,000 units annually. This demand level is expected to continue for at least another four years. To expand manufacturing capacity and take advantage of the demand, Nil Hill must acquire equipment costing $995,000. The equipment will double the current production quantity. This equipment has a useful life of 10 years and can be sold for $195,000 at the end of year 4 or $35,000 at the end of year 10. Analysis of current operating data provides the following information:

			Per Unit
Sales price			$195
Variable costs
Manufacturing	$90
Marketing	10	$100
Fixed costs
Manufacturing	$45
Other	25	70	170
Pretax operating income			$ 25

The fixed costs include depreciation expense of the current equipment. The new equipment will not change variable costs, but the firm will incur additional fixed manufacturing costs (excluding depreciation) of $250,000 annually. The firm needs to spend an additional $200,000 in fixed marketing costs per year for additional sales. Nil Hill is in the 30 percent tax bracket. Management has set a minimum rate of return of 14 percent after-tax for all capital investments. Assume, for simplicity, that MACRS depreciation rules do not apply.

Required

1. Assume that the equipment will be depreciated over a four-year period. What effects will the new equip­ment have on after-tax operating income in each of the four years?

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2. What effect will the new equipment have on cash flows in each of the four years?

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3. Compute the proposed investment’s payback period (in years), under the assumption that cash inflows occur evenly throughout the year.

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4. Compute the book rate of return (ARR) based on the average investment.

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5. Compute the net present value (NPV) of the proposed investment.

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6. Compute the internal rate of return (IRR) of the proposed investment.

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7. Compute the modified internal rate of return (MIRR) for the proposed investment.

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8. Management has decided to invest in the new equipment, but is unsure of the reliability of some of the estimates and as such has asked some what-if questions. Treat each of the following two cases independently.

?a. By how much can the unit variable cost for units produced by the new equipment increase and still justify the purchase of the equipment (i.e., have the investment generate an after-tax IRR of exactly 14 percent, its cost of capital)?

?b. The company is anticipating an increase in competition. Management believes that, in response, it will have to reduce the selling price of the product. By how much can the firm decrease the selling price (of all units sold) and still be able to justify the purchase of the new equipment?

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9. What strategic considerations might bear on this investment decision? How can such considerations be dealt with formally in the planning and decision-making process?

Step 1 of 12

The prearrangement of long-term investment in the productive asset is known as capital budgeting. A company uses a diverse mixture of capital sources. Its capital can be raised through new debt or equity or from available cash. The mix of capital is subject to many features like market circumstances and attitude of the members of the board of directors and people of management.