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$10,000

Net profits before tax $26,667 $43,333

T x (40%)

a 10.667 17.333

4,000 ˜˜˜

$ 6,000

Net profits after tax $26,000

$16,000

50,000 33,333

Depreciation 16.667

$56,000

After-tax cash inflow $49,333 $42,667

232 CAPITAL BUDGETING (INCLUDING LEASING) [CHAP. 8

After-Tax Cash M o w ($) PV of $1

Year Total PV ($, Rounded)

(b)

56,000

1 0.9091 $50,910

2 49,333 0.8264 40,769

42,667 0.7513 32,056

3

0.7513 4.508

6,000"

$128,243

The $6,000 cash inflow is computed as follows:

a

Salvage value $lO,OQo

Book value 0

Gain

Tax (40%)

After-tax gain

NPV = PV - 1

= $128,243 - $lOO,oo<l˜

$28,243

Since NPV is positive, the company should purchase the computer, replacing the manual bookkeeping

system.

Replacement Decision. Wisconsin Products Company manufactures several different products.

8.18

One of the firm's principal products sells for $20 per unit. The sales manager of Wisconsin

Products has stated repeatedly that he could sell more units of this product if they were available.

In an attempt to substantiate his claim the sales manager conducted a market research study last

year at a cost of $44,000to determine potential demand for this product. The study indicated that

Wisconsin Products could sell 18,000 units of this product annually for the next 5 years.

The equipment currently in use has the capacity to produce 11,000 units annually. The

variable production costs are $9 per unit. The equipment has a book value of $60,000 and a

remaining useful life of 5 years. The salvage value of the equipment is negligible now and will

be zero in 5 years.

A maximum of 20,000 units could be produced annually on new machinery. The new

equipment costs $300,000and has an estimated useful life of 5 years, with no salvage value at the

end of 5 years. Wisconsin Products' production manager has estimated that the new equipment,

if purchased, would provide increased production efficiencies that would reduce the variable

production costs to $7 per unit.

Wisconsin Products Company uses straight-line depreciation on all its equipment for tax

purposes. The firm is subject to a 40 percent tax rate, and its after-tax cost of capital is 15percent.

The sales manager felt so strongly about the need for additional capacity that he attempted

to prepare an economic justification for the equipment although this was not one of his

responsibilities. His analysis, presented below and on the next page, disappointed him because

it did not justify acquisition of the equipment.

He computed the required investment as follows:

Purchase price of new equipment $300,000

Disposal of existing equipment

Loss on disposal $60,000

Less tax benefit (40%) 24,000 36,000

Cost of market research study 44.000

Total investment $380,000

233

CAPITAL BUDGETING (INCLUDING LEASING)

CHAP. 81

He computed the annual returns as follows:

Contribution margin from product

Using the new equipment

[18,000 X ($20 - $7)] $234,000

Using the existing equipment

[11,000 x ($20 - $9)] 121,000

$113,000

Increase in contribution margin

60,000

Less depreciation

$53,000

Increase in before-tax income

2 1,200

Income tax (40%)

$ 31,800

Increase in income

Less 15% cost of capital on the

additional investment required

57,000

(0.15 X $380,000)

Net annual return on proposed

$ (25,200)

investment in new equipment

The controller of Wisconsin Products Company plans to prepare a discounted cash flow

analysis for this investment proposal. The controller has asked you to prepare corrected

calculations of ( a ) the required investment in the new equipment and ( b )the recurring annual

cash flows. Explain why your corrected calculations differ from the original analysis prepared by

the sales manager. (c) Calculate the net present value of the proposed investment in the new

equipment.

SOLUTl0N

( a ) The initial investment is:

Purchase price of new equipment $300,000

-Tax savings from loss on disposal" 24,000

$276,000

"Tax savings are computed as follows:

Loss = selling price - book value

= ($0 - $60,000) = $60,000

Tax rate 0.4

Tax savings $24,000

( b ) Using the shortcut method, the annual cash flows are computed by first determining the increased cash

flows resulting from change in contribution margin:

Using new equipment

[18,000 ($20 - $7)]" $234,000

Using existing equipment

[11,000 ($20 - $9)] 121.WO

Increased cash flows $113,000

Taxes (0.40 X $113,000) 45.200

Increased cash flows after taxes $ 67,800

234 CAPITAL BUDGETING (INCLUDING LEASING) [CHAP. 8

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