CAPITAL BUDGETING
Myer Inc. would like to set up a new plant. Currently, Myer has an option to buy an exsiting building at a cost of $24,000. Necessary equipment for the plant will cost $16,000, including installation costs. Depreciation of the equipment and of the building is as follows:
Year 1=$3512, Year 2= $5744, Year 3=$3664, and Year 4= $2544.
The project would require an initial investment of $12,000 of net working capital and will be made at the time of the purchase of the building and equipment. The working capital will be fully recovered at end of year 4.
The project’s estimated economic life is four years. At the end of that time, the building is expected to have a market value of $15,000 and a book value of $21,816, whereas the equipment is expected to have a market value of $4000 and a book value of $2720.
Annual sales will be $80,000. The production department has estimated that variable manufacturing costs will be 60% of sales and that fixed overhead costs, excluding depreciation, will be $10,000 a year.
Myer’s marginal tax is 30%; its cost of capital is 12% and for capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.
Questions:
1.Initial Investment
How much is the Net Initial investment (Outlay) of the project?
2.Annual Incremental Cash Flows of the project from year 1 to 4.
a.How much is the total cost of the production per year?
b.How much is the annual incremental EBIT?
c.How much is the annual incremental operating cash flows after tax?
3.Terminal Cash Flows in Year 4
a.How much is the sale of new building and equipment at the end of year 4?
b.How much would Myer receive from Tax shield if the building is sold at the end of year 4?
c.How much is the capital gain tax if the equipment is sold at the end of year 4?
d.How much is the after-tax non-operating cash flows in the terminal year?
4.Determine whether the project should be accepted using NPV analysis.
5.Perform a sensitivity analysis on NPV of the project on the following scenarios:
a.Sales increases/decreases by 10%.
b.Cost of capital increases/decreases by 10%.
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