29 Dec Tax savings due to

Capital Budgeting Decision

Here is Project 2:

HamptonCompany is a producer of house paints. The company’s production department has been investigating possible ways to trim total production costs. One possibility currently being examined is to make the paint cans instead of purchasing them. The equipment needed would cost $1,000,000, with a disposal value of $200,000, and would be able to produce 27,500,000 cans over the life of the machinery. The production department estimates that approximately 5,500,000 cans would be needed for each of the next 5 years.

The company would hire six new employees to produce the paint cans. These six individuals would be full-time employees working 2,000 hours per year and earning $15.00 per hour. They would also receive the same benefits as other production employees, 15% of wages in addition to $2,000 of health benefits.

It is estimated that the raw materials will cost 30¢ per can and that other variable costs would be 10¢ per can. Because there is currently unused space in the factory, no additional fixed costs would be incurred if this proposal is accepted.

It is expected that cans would cost 50¢ each if purchased from the current supplier. The company’s minimum rate of return (hurdle rate) has been determined to be 11% for all new projects, and the current tax rate of 35% is anticipated to remain unchanged. The pricing for thecompany’s products as well as number of units sold will not be affected by this decision. The unit-of-production depreciation method would be used if the new equipment is purchased.

Required:

1. Based on the above information and using Excel, calculate the following items for this proposed equipment purchase.

Annual cash flows over the expected life of the equipment
Payback period
Simple rate of return
Net present value
Internal rate of return
The check figure for the total annual after-tax cash flows is $271,150.

2. Would you recommend the acceptance of this proposal? Why or why not? Prepare a short, double-spaced paper in MS Wordelaborating on and supporting your answer.

ACCT505

Project 2

Template For ACTUALWeek Seven Capital Budgeting Problem

This file can be used as the template for the actual project.

Hampton Company

Data:

Cost of new equipment

$10,00,000

Expected life of equipment in years

5

Disposal value in 5 years

$2,00,000

Life production—number of cans

2,75,00,000

Annual production or purchase needs

55,00,000

Number of workers needed

6

Annual hours to be worked per employee

2,000

Earnings per hour for employees

$15

Annual health benefits per employee

$2,000

Other annual benefits per employee—% of wages

15%

Cost of raw materials per can

$0.30

Other variable production costs per can

$0.10

Costs to purchase cans—per can

$0.50

Required rate of return

11%

Tax rate

35%

Make

Purchase

Cost to Produce

Annual cost of direct material:

Need of 5.5 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

Part 1 Cash Flows Over the Life of the Project

Before Tax

Tax

After Tax

Item

Amount

Effect

Amount

Annual cash savings

Tax savings due to depreciation

Total after-tax annual cash flow

Part 2 Payback Period

years

Part 3 Simple 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

After tax income / Investment Cost

Part 4 Net Present Value

Before Tax

After Tax

11% PV

Present

Item

Year

Amount

Tax %

Amount

Factor

Value

Cost of machine

Annual cash savings

Tax savings due to depreciation

Disposal value

Net Present Value

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.

After Tax

Item

Year

Amount

Cost of machine and training

0

Year 1 inflow

1

Year 2 inflow

2

Year 3 inflow

3

Year 4 inflow

4

Year 5 inflow

5

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)