Question

Mini Case #1: Capital Budgeting at Rio Negro, Inc.

Assignment Overview Rio Negro, Inc.

(RNI) is in the business of transporting cargo between ports in California and Washington. Its fleet includes a small dry-cargo vessel, the Maracas. The Maracas is 25 years old and badly in need of an overhaul. It is March 2016, and Michael John, the finance director, has just been presented with a proposal that would require the one-time expenditures shown below in Table 1. If the proposal is accepted, these expenditures will be made in the next few days. Mr. John believes that all these outlays could be depreciated for tax purposes in the seven-year MACRS class (see Table 2 below for rates). Overhaul of the Maracas will begin as soon as the expenditures in

Table1 are made, but the vessel will be out of service for several months. The overhauled vessel would resume commercial service in one year. RNI’s chief engineer’s estimates of the post-overhaul operating costs are in

Table 3. In addition to the overhaul described above, the chief engineer suggests installation of a brand- new engine and control system. Installation of this new engine would cost an extra $600,000 (This additional outlay would also qualify for tax depreciation in the seven-year MACRS class.). However, if the additional equipment is installed, it would result in reduced fuel, labor, and maintenance costs as shown in

Table 4. The operating cost estimates in Tables 3 and 4 are current for March 2016. However, these costs will increase with inflation, which is forecasted at 1.25% a year. Depreciation and operating costs attributable to the overhaul of the Maracas will begin one year after the vessel is put back into commercial service. The revenues from operating the vessel will be the same for both types of overhaul. Even with the proposed overhaul, the Maracas cannot continue forever. After the overhaul, its remaining useful life is estimated to be only 12 years. Its salvage value when finally taken out of service will be trivial. Thus, Mr. John feels it is unwise to proceed without also considering the purchase of a new vessel. Racette & Sons (R&S), a Colorado shipyard, has approached RNI with a design incorporating a Kort nozzle, extensively automated navigation and power control systems, and much more comfortable accommodations for the crew. R&S is offering the new vessel for a fixed price of $3,000,000, payable half immediately and half on delivery in one year. Estimated annual operating costs of the new vessel are in Table 5. The operating cost estimates in the table are current for March 2016, but will increase with inflation. The crew would require additional training to handle the new vessel’s more complex and sophisticated equipment. Training would result in a one-time cost of $50,000 payable one year following delivery of the new vessel. This cost is tax deductible. The estimated operating costs for the new vessel assume that it would be operated in the same way as the Maracas. However, the new vessel will be able to handle a larger load on some routes, which is expected to generate additional revenues of approximately $175,000 per year in the first year of operation. These revenues are expected to grow at the rate of inflation. Revenues and operating costs from the new vessel will begin one year after it is delivered. The new vessel is estimated to have a useful service life of 20 years, but it will be depreciated for tax purposes according to the 7-year MACRS schedule. The new vessel is not expected to have any resale value at the end of its 20-year useful life. All revenues and costs (including depreciation) associated with the new vessel will begin one year after it is delivered. The Maracas is carried on RNI’s books at a book value of only $100,000 and the book value of the spare parts is $40,000. The Maracas could probably be sold now “as is,” together with its extensive inventory of spare parts, for $200,000. Mr. John stepped out on the foredeck of the Maracas as she chugged down the Cook Inlet. “A rusty old tub,” he muttered, “but she’s never let us down. I’ll bet we could keep her going until next year while Racette & Sons are building her replacement. We could use up the spare parts ($40,000) to keep her going and we should even be able to sell or scrap her for book value when her replacement arrives.” RNI evaluates capital investments of this type using a 8.5% cost of capital. (This is a nominal, not real, rate.) RCI’s tax rate is 35%.

Table 1: Overhaul Expenditures Overhaul engine and generators $340,000 Replace radar and other electronic equipment 75,000 Repairs to hull and superstructure 310,000 Painting and other repairs 95,000 $820,000 Table 2: Depreciation (in %) for the 7-year Modified Accelerated Cost Recovery System Year 1 14.29 Year 2 24.49 Year 3 17.49 Year 4 12.49 Year 5 8.93 Year 6 8.93 Year 7 8.93 Year 8 4.45 Table 3: Post-overhaul Operating Costs (Basic Overhaul) Fuel $450,000 Labor and benefits 480,000 Maintenance 141,000 Other 110,000 $1,181,000 Table 4: Post-overhaul Operating Costs (Overhaul plus new engine & control system) Fuel $400,000 Labor and benefits 405,000 Maintenance 105,000 Other 110,000 $1,020,000 Table 5: Operating Costs of New Vessel Fuel $380,000 Labor and benefits 330,000 Maintenance 70,000 Other 105,000 $885,000 Guidelines for Case Analysis The following aids are permitted for this analysis: You may use internet sources, books, all posted materials (including Discussion Board Q&A), and your notes. Any other aids are unauthorized and their use constitutes a violation of academic integrity.

1. Introduction

2. Analysis

3. Conclusion

The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis. Your report should not exceed five pages of double-spaced text with 1 inch margins at the sides, top, and bottom of the page. This does not include exhibits of your computations. You may submit one Excel Spreadsheet that contains all your exhibits, clearly labeled, and appropriately referenced in the text of your report. Your analysis of “Rio Negro, Inc.” should consist of answers to the questions below. Do not write the questions verbatim in your report. Instead, write a brief introductory statement that summarizes the question before you proceed with your analysis.

4. Calculate the present value of the proposed overhaul of the Maracas, with and without the new engine and control system. Should RNI do the basic overhaul or the expanded overhaul with the new engine and control system? For the moment, ignore the option to purchase a new vessel (you will evaluate that option in question 2 below). Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 1.

5. Calculate the present value of buying and operating the new vessel. What, if any, additional information would be useful to you in your analysis? Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 2.

6. Calculate the equivalent annual costs of (a) overhauling and operating the Maracas for 12 more years (with and without the new engine and control system) and (b) buying and operating the proposed replacement vessel for 20 years. You should use the real discount rate for this analysis. Based on your answer, what should RNI do? Write one to two paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 3.

7. Why is the equivalent annual cost method potentially useful in decision making in this case? Why would you use the real discount rate to compute the EAC? What problem(s) do you see with using the equivalent annual cost method to evaluate RNI’s options? One to two paragraphs. Your report is intended for the senior management of Rio Negro, Inc., so be sure that you write in a professional style that is easy to follow.

Can you please answer question 5 only? Thanks!

Answer 1

Que.5   "Calculate the present value of buying and operating the new vessel. What, if any, additional information would be useful to you in your analysis? Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 2."                                                                                                                                                                   
                                                                                                  
                                                                                                  
   The present value of buying and operating the new vessel                                                                                              
                                                                                                  
   At the beginning of year                   Year 0   Year 1   Year 2   Year 3   Year 4   Year 5   Year 6   Year 7   Year 8   Year 9   Year 10   Year 11   Year 12   Year 13   Year 14   Year 15   Year 16   Year 17   Year 18   Year 19
   R&S is offering the new vessel for a fixed price                   "$30,00,000 "                                                                          
   payable half immediately and half on delivery in one year                                                                                              
                                                                                                  
a   The Present obligation to pay for the new vessel                   "$15,00,000 "   "$15,00,000 "   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0
b   "The Maracas could probably be sold now ?as is,? together with its extensive inventory of spare parts"                   "$2,00,000 "   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0
c   Training would result in a one-time cost payable one year following delivery of the new vessel                   "$50,000 "   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0
d   Operating Costs                       "$8,96,063 "   "$9,07,263 "   "$9,18,604 "   "$9,30,087 "   "$9,41,713 "   "$9,53,484 "   "$9,65,403 "   "$9,77,470 "   "$9,89,689 "   "$10,02,060 "   "$10,14,585 "   "$10,27,268 "   "$10,40,109 "   "$10,53,110 "   "$10,66,274 "   "$10,79,602 "   "$10,93,097 "   "$11,06,761 "   "$11,20,596 "
   Sum (a-b+c+d)                   "$13,50,000 "   "$23,96,063 "   "$9,07,263 "   "$9,18,604 "   "$9,30,087 "   "$9,41,713 "   "$9,53,484 "   "$9,65,403 "   "$9,77,470 "   "$9,89,689 "   "$10,02,060 "   "$10,14,585 "   "$10,27,268 "   "$10,40,109 "   "$10,53,110 "   "$10,66,274 "   "$10,79,602 "   "$10,93,097 "   "$11,06,761 "   "$11,20,596 "
                                                                                                  
   Present Value Factor for 8.5%           RNI evaluates capital investments of this type using a 8.5% cost of capital.       1.0000   0.9217   0.8495   0.7829   0.7216   0.6650   0.6129   0.5649   0.5207   0.4799   0.4423   0.4076   0.3757   0.3463   0.3191   0.2941   0.2711   0.2499   0.2303   0.2122
   Present Value                   "$13,50,000 "   "$22,08,353 "   "$7,70,680 "   "$7,19,183 "   "$6,71,127 "   "$6,26,282 "   "$5,84,433 "   "$5,45,381 "   "$5,08,939 "   "$4,74,931 "   "$4,43,196 "   "$4,13,582 "   "$3,85,946 "   "$3,60,157 "   "$3,36,091 "   "$3,13,634 "   "$2,92,677 "   "$2,73,120 "   "$2,54,870 "   "$2,37,839 "
                                                                                                  
   Total Present Value of buying and operating the vessel                   "$1,17,70,421 "                                                                          
   Operating Cost                                                                                              
   Fuel                   "$3,80,000 "   "$3,84,750 "   "$3,89,559 "   "$3,94,429 "   "$3,99,359 "   "$4,04,351 "   "$4,09,406 "   "$4,14,523 "   "$4,19,705 "   "$4,24,951 "   "$4,30,263 "   "$4,35,641 "   "$4,41,087 "   "$4,46,600 "   "$4,52,183 "   "$4,57,835 "   "$4,63,558 "   "$4,69,353 "   "$4,75,219 "   "$4,81,160 "
   Labor and Benefits                   "$3,30,000 "   "$3,34,125 "   "$3,38,302 "   "$3,42,530 "   "$3,46,812 "   "$3,51,147 "   "$3,55,536 "   "$3,59,981 "   "$3,64,480 "   "$3,69,036 "   "$3,73,649 "   "$3,78,320 "   "$3,83,049 "   "$3,87,837 "   "$3,92,685 "   "$3,97,594 "   "$4,02,564 "   "$4,07,596 "   "$4,12,691 "   "$4,17,849 "
   Maintenance                   "$70,000 "   "$70,875 "   "$71,761 "   "$72,658 "   "$73,566 "   "$74,486 "   "$75,417 "   "$76,360 "   "$77,314 "   "$78,280 "   "$79,259 "   "$80,250 "   "$81,253 "   "$82,268 "   "$83,297 "   "$84,338 "   "$85,392 "   "$86,460 "   "$87,540 "   "$88,635 "
   others                   "$1,05,000 "   "$1,06,313 "   "$1,07,641 "   "$1,08,987 "   "$1,10,349 "   "$1,11,729 "   "$1,13,125 "   "$1,14,539 "   "$1,15,971 "   "$1,17,421 "   "$1,18,888 "   "$1,20,375 "   "$1,21,879 "   "$1,23,403 "   "$1,24,945 "   "$1,26,507 "   "$1,28,088 "   "$1,29,690 "   "$1,31,311 "   "$1,32,952 "
   Total Operating Costs                   "$8,85,000 "   "$8,96,063 "   "$9,07,263 "   "$9,18,604 "   "$9,30,087 "   "$9,41,713 "   "$9,53,484 "   "$9,65,403 "   "$9,77,470 "   "$9,89,689 "   "$10,02,060 "   "$10,14,585 "   "$10,27,268 "   "$10,40,109 "   "$10,53,110 "   "$10,66,274 "   "$10,79,602 "   "$10,93,097 "   "$11,06,761 "   "$11,20,596 "
                                                                                                  
   Inflation @ 1.25% a year                   "$11,063 "