BARRETT CORPORATION CASE : CAPITAL BUDGETING

The Barret Corporation is a medium sized cable manufacturing company in northern

Indiana, approximately 40 miles from Chicago. Founded in 1923, the company has expanded
steadily and has developed solid contacts with utilities in a number of midwestern states. The
company has several long term contracts with firms, including subsidiaries of American
Telephone & Telegraph.

Barret's management has been particularly interested in taking advantage of the demand
for soft, fully annealed copper wire that is used in insulated conductors in communication and
power systems. The executive committee of the firm has been discussing an expansion of wire
drawing facilities to meet anticipated demand.

To gain the most recent information, Joe, the firms controller, went to the 1988 wire
association convention to review the various types of machines available. He paid particular
attention to manufacturers with machinery that promised high production and consistent quality.
After three days of discussion with a variety of production and industry experts, Joe called
George, a representative for a miling and machinery firm in Cincinnati. Joe asked George to send
him some of the details on the machinery that they had discussed and George agreed to do so.
Two weeks later, Joe received a letter from George (a)

EXHIBIT A

Dear, Mr Hall :
In response to your inquiry, I am pleased to suggest a machine that would amply meet
your needs for high quality fully annealed copper wire.
I refer to the MX900 model, probably the finest full production wire drawing machine on
the market today. The wire drawing machine and annealer are an integral unit with the special
electronic controls that allow the annealer to work during start-up procedures. Your production
manager will well understand how this excellent machine offers lower operating costs due to less
scrap and simplified operating procedures.
If you order one of these machines by Januari 1, 1989, and make the required deposit, I
will personally guarantee that the machine will be set up and operating by Januari 1, 1990. And I
will be further able to guarantee that you will receive our 1989 price less a 10% discount, an
attractive offer indeed! The pricing is as follows
MX900
1988 price $5,000,000
Less 10% discount $500,000
Net full price $4,500,000
+ shipping and installing $400,000
Fully installed price $4,900,000
Deposit (Jan 1, 1989) $1,900,000
 Balance due (Jan 1, 1990) $3,000,000
As an item of interest, you should know that our prices have already risen by 5% on these
machines and will rise another 8% on Januari 1. By ordering and paying your deposit prior to
January 1, you in effect will be saving 23% compared to an order placed in 1989, when I
probably will not be able to offer any discount.
If you need any additional information, please do not hesitate to call me. I look forward to
hearing from you in the near future.
-George Gray

After reading the letter carefully and makin some notes on it, Joe sent a memorandum to
Nick, the firms production manager, and Lew, the firms senior production accountant. He asked
both men to respond to the letter from George and to ansnwer some question related to other
aspects of the investment decision. Three days later, Joe received Nick's reply to see (b)

EXHIBIT B

From : Nick Schaler (manajer produksi)

To : Joe Halli

We should seriously consider this machine. We could buy it and get rid of an old MX430, which
we bought 2 yaers ago from the same firm. The MX430 works fine and I’d bet that we could get
$1.2 million if we sold it in Janyary 1990 – pretty good since we only paid $1.8 million for it and
its book value on January 1, 1990 will only be $900,000 (we’re depreciating it at $300,000 a year
drown to a zero book value). According to what I’ve heard, the MX900 is so efficient that we
could probably eliminate some $250,000 of inventory around here once the machine was fully
operational. This is important, but more importantly, the machine will save us money, so I think
it would make sense to make a replacement with the MX900.

Two days after receiving Nick's memorandum, Joe received a reply from Lew (c).

EXHIBIT C

From : Lew Wallis (senior production accountant)

To : Joe Halli

I got copy of Nick’s memo and we had better think twice on this new machine. By 1993, I’d bet
either of these new machines would be a piece of junk. I made a couple of phone calls and
learned that this new machine is just too sophisticated for longterm use. Our MX430 will
probably worth $750,000 at the end of 1993. Do you know what my “expert” estimate the new
machine would be worth? $500,000 for the almost $5 million MX900. Some cash value in 4
years, heh? But that’s the price of buying fancy equipment. And everybody knows this. Even
with a 200 percent declining balance depreciation schedule over 7 years to a zero book value,
this machine is not reasonable. And the MX900 for $5 plus million? You’ll never convince me
that it make sense. I think Nick’s just not thinking and I STRONGLY urge you to stay with our
existing machine.

Before Joe had a chance to consider either of the positions, he got a second memorandum
from Nick (d)

EXHIBIT D

From : Nick Schafer

To : Joe Halli

Hold it! Stop! Whatever happened to production efficiency? Lew’s memo does not even touch
on the rather impressive economics offered by each machine. I have done some quick figures and
the MX900 will save us a bundle. I’ve figured in a few probabilities and just look at the annual
benefits with this machine :

At Present With MX900

Revenues 12,000,000 13,500,000
Cash Expenses 7,000,000 6,000,000

These are big savings. Even if we only got them for 4 years, we would be ahead with any of the
machines. Don’t give up the ship.

After receiving the final memorandum, Joe called Lew. Lew said that he helped Nick
work out the figures on the annual revenues and expenses and Lew indicated that the percentages
and dollar figures were logical and probably correct. But Lew insisted that the pirchase of new
machinery still did not make sense because the machinery was simply too expensive.

That night, Joe took the memorandum home to decide whether the MX900 would provide
a return equal to or greater than the firms 14 percent aftertax required return.

Question :

1. What is the net cash outlay (2 years) for the new machine?
2. Prepare a cash-flow stream for each new machine, assuming that each machine would
become operational on January 1, 1990
3. What is the rate of return for the MX900?
4. What are the NPV for the MX900?
5. Is the machine acceptable?