Capital Budgeting Decisions

Application

• The wine company Les Grands Vins Martel is considering the possibil-
ity to replace its old machinery with more productive equipment.

• There are presently two types of machine available on the market.

• Machine A:

– Purchase price (Capex): 750 000e

– Linear depreciation
– Increase in annual sales: 300 000e over 5 years
– Increase in annual production costs: 50 000e over 5 years
– WCR: 5% of sales
– Estimated resale value (market) after 5 years: 100 000e

• Machine B:

– Purchase price (Capex): 1 000 000e

– Linear depreciation
– Increase in annual sales: 400 000e over 5 years
– Increase in annual production costs: 50 000e over 5 years
– WCR: 5% of sales
– Estimated resale value (market) after 5 years: 150 000e

• Corporate tax rate: 30%.

• Cost of capital (discount rate): 10%

Compare these two alternatives on the basis of the NVP criteria.

 Solution
Machine A:

• Capex: - 750 000 (t=0)

• Annual depreciation: 20% × 750 000 = 150 000

• Annual tax savings on depreciation: 30% × 150 000 = 45 000

• Increase in EBITDA (after tax): (300 000 − 50 000) × 0, 7 = 175 000 /

year for 5 years

• Increase in WCR (t=1): −300 000 × 0.05 = −15 000

• Recovery of the WCR (t=5): 15 000

• Resale of the machine after 5 years: 100 000 (t=5)

• Tax on capital gain (CG): - 0,3 × 100 000 = - 30 000 (t=5)

   
45 000 1 175 000 1
NPV(A) = −750 000 + 1− + 1−
0.1 (1.1)5 0.1 (1.1)5
15 000 15 000 (100 000 − 30 000)
− + +
1.1 (1.1)5 (1.10)5
= 123 115

Machine B:

• Capex: - 1 000 000 (t=0)

• Annual depreciation: 20% × 1 000 000 = 200 000

• Annual tax savings on depreciation: 30% × 200 000 = 60 000

• Increase in EBITDA (after tax): (400 000 − 50 000) × 0, 7 = 245 000 /

year for 5 years

• Increase in WCR (t=1): −400 000 × 0.05 = −20 000

• Recovery of the WCR (t=5): 20 000

2
 • Resale after 5 years: 150 000

• Tax on capital gain (CG): - 0,3 × 150 000 = - 45 000 (t=5)

   
60 000 1 245 000 1
NPV(B) = −1 000 000 + 1− + 1−
0.1 (1.1)5 0.1 (1.1)5
20 000 20 000 (150 000 − 45 000)
− + +
1.1 (1.1)5 (1.1)5
= 215 623

Conclusion: Machine B is preferred to Machine A.