Question

Capital Budgeting: Estimating Cash Flows for an Investment

A company is considering replacement of manufacturing equipment with computer controlled equipment, at a cost of $500,000, replacing equipment with a scrap value of $50,000. This will reduce defect costs by $150,000 a year. At the end of 7 years, the equipment will be replaced and will have a scrap value of $100,000. The interest charges for financing the purchase will be $25,000 a year. The new system will be housed in a building that is currently unused, with an overhead value of $10,000 a year. Utility costs will be unchanged. Machine operators will require training of $1000 each for 4 workers. These workers are scheduled for a raise of $3000 each. Because the new equipment technology is well-established for its intended use, the risk premium for the project is considered to be 2 percentage points less than the company’s WACC of 8%.                 

1A. List the investment facts for the project:

NOTE: List all of the financial details associated with the project and designate which should be included (and which ignored) in calculating the project’s cash flows and its cost of capital.

Life of the project:_________

Interest rate for the project:             _______ (cost of capital to the firm adjusted for project risk)

PVIF for the project:           _______

PVIFA for the project:        _______

Initial investment: (include all cash flows - positive and negative - that occur at the beginning of the project)

Future cash flows: (negative and positive)

Lump sum: (one time)

Annuity: (repeated annually)

Costs that you will ignore: (sunk cost or otherwise)

1B. Using the relevant net cash flows and cost of capital from A above, calculate the NPV for the project. (use the NPV formula and the PV tables)

It says the risk premium for the project is considered to be 2 percentage points less than the comapny's WACC of 8%

So the risk premium would be 6%

This is how the question is on our test! What more do you need!?!?!? Can you not let someone else answer since you are clueless?!?!?!

Answer 1

Hello,

Financial Facts of the project:

1. Initial investment required = $ 500,000. It replaces an older equipment and the company gains scrap value of $ 50,000. Therefore, net initial investment required = $450,000

The company would also need to train 4 workets at $1000 each = $4,000. We can safely assume that this needs to be done at Year 0, ie. at the beginning of the project.

2. Interest Charges = $ 25,000 per year

3. Cash Inflow from operations = $ 150,000 per year

4. Scrap Value of the equipment at the end of 7 years = $ 100,000

5. Cost of capital for the project = 8% - 2% = 6%

6. Other factors - Workers' raise was anyways scheduled. There is no incremental charge due to this new equipment

Overhead value for building that is used will not matter as the building was unused. The overhead expenses was anyways being incurred. Had the project displaced an existing project being housed in that building, we would have taken into account the incremental expenses.

There is no increase in the utility bills.