CAPITAL BUDGETING PROBLEMS

1) ABC Ltd. is one of the finest producers of gourmet spaghetti in Nova Scotia. Management
is considering purchasing a new spaghetti harvesting machine. The new machine will be
more efficient and less spaghetti will remain on the trees. There will be a reduction in
costs as a result of lower amounts of damage to the product that is harvested. This will
allow the company to maintain constant production levels and meet the excess demand in
the market. The new equipment costs $275,000 and will require shipping and delivery
costs of $4,500 as well as installation costs of $5,500. Management has estimated that
the additional production will increase sales revenues $170,000 per year however,
operating costs will increase by $60,000. As well, the damage to the product as a result
of the harvesting will decrease by $10,000 per year. The harvesting equipment belongs
to a CCA class that has a 25% CCA rate. The new equipment has a useful life of 4 years
after which it can be salvaged for $120,000. If the new equipment is purchased, ABC will
require an increase of $18,000 in cash and marketable securities and an increase of
$8,500 in inventory. To finance part of the investment in current assets, accounts payable
will have to increase by $5,500. All investments in net working capital will be fully
recovered at the end of the useful life. The additional increase in the market size was
revealed by a marketing survey that was completed one year ago. ABC needs to pay the
marketing firm $5,000 for the market survey. Assume ABC Ltd. cost of capital is 12%
and the firm has a 40% tax rate. The CCA class will remain open at the end of the project.
Based on NPV analysis, should the project be accepted?

2) Last year, your firm paid $4000 to a consulting firm to recommend ways of increasing
efficiency. The consultants have now given you their report and they recommend a
particular piece of equipment for the factory. It will cost $1,000,000 to purchase. It
would also require $40,000 to be paid to a supplier in order to have the equipment
installed. It would also require $10,000 to be paid to a shipping firm to have the
equipment delivered. The equipment would reduce labour costs by $210,000 per year for
the five years that the equipment is operational. Costs of maintenance on the equipment
are $12,000 per year. The new equipment would require keeping an additional $12,000
of inventory on hand. In five years, the equipment will be sold in the second hand market
and it is expected to be sold for $700,000 at that time. The equipment falls in an asset
class with a CCA rate of 10%. The firm has millions of dollars of assets in this class
already. The firm’s tax rate is 35%. This equipment will take up part of the factory that the
firm has not been using. Prior to consideration of this equipment, the firm was considering
renting out the floor space. The firm could get $6,000 per year in rent if they do not buy
the equipment. If the firm could earn a 13% return on other investments of equal risk to
this equipment, should the firm purchase the equipment? What does your answer suggest
about the IRR of the project?

3) You are an entrepreneur who delivers pizza. You deliver pizza for some of the large chains
in the area and charge them on a per pizza basis. To make deliveries, you are using a 2005
Toyota Tercel. The Tercel costs $2000 per year in gas and $2,000 per year in repairs.
You expect that you could keep the Tercel running for another 5 years, when you will have
to sell it for scrap. You estimate that you will be able to get $500 for it at that time.
You are thinking about buying a new car to replace the Tercel. You are considering buying
a new 2010 Honda Civic. The Civic will cost $19,000 and there would be a $500 delivery
charge. The Civic will cost $1,500 per year in gas and only $100 per year in maintenance
costs (it is under warranty). Also, because the car is faster, you will be able to deliver more
pizzas and you expect revenues to increase by $500 per year. If you buy the new car, you
CAPITAL BUDGETING PROBLEMS

will sell the Tercel and you expect to get $3000 for it now. The Civic would be sold in five
years for $10,000. The new Civic would be financed through the dealership at an interest
rate of 12% per year, compounded monthly. Given that your tax rate is 35%, that your cars
depreciate for tax purposes at 15% per year and that the asset class for these cars will
always remain open (you have other cars in the asset class) and that you require a 15%
return on any money you invest in your business, should you replace your car?

4) Wholegrain breads Ltd. Produces natural ingredient breads that are sold exclusively
through health food stores. The firm is considering expanding into supplying the local
mass supply food supply chains. The company paid $10,000 to a management consultant
firm for a marketing study and strategic advice. The consultants concluded that there is a
strong growth potential in the health food industry in general and for Wholegrain
specifically given its unique product lines.
The expansion will require the purchase of two new vans at $28,000 each and the
purchase of new baking equipment for $120,000. The vans belong to class 10 (CCA rate
30%) and the baking equipment belongs to class 43(CCA rate 25%). Both assets will have
a useful life of four years. It will cost the firm $5,000 to have the bakery equipment
delivered to the production facility and an additional $2,000 for installation. The project
will result in an increase of $3,000 in accounts receivable, an increase of $3,000 in
average inventory and an increase of $1,000 in accounts payable.
The expansion is expected to generate sales of $200,000 per year in the supermarket
chains; however sales to the local health food outlets are expected to decrease by $25,000
per year. Labour and operating costs are expected to be $100,000; however, the labour
costs for the existing production line will decrease by $15,000.
It is expected that the baking equipment will have a salvage amount of $59,062 and the
vans will be worth $23,325 (in total) at the end of the project. Assume the asset classes
will remain open and that the company is in the 40% tax bracket. The company requires a
12% return on its investments. Should the company undertake the project?

5) Rinki Dink Inc. is considering purchasing a new machine that will cost $550,000 plus an
additional $125,000 in installation costs. Management estimates that the firm will obtain
annual operating revenues before taxes of $500,000 and incur annual operating
expenses before taxes of $275,000 over the economic life of the project. The
specifications of this machine indicate an economic life of ten years and management
estimates that at the end of the economic life, the machine will have a salvage value of
$100,000. This machine is in asset class 9 which has a CCA rate of 15%. The firm
requires $75,000 in additional working capital to start up the project and management
estimates that the $75,000 will be released at the end of the project. The firm’s required
rate of return is 12% and the firm’s tax rate is 45%. If the asset class is expected to remain
open at the end of the project, based on NPV analysis, should the project be undertaken?

6) The Tinky Winky Corporation is the world’s leading manufacturer of tinky winkies is
considering the replacement of a hand operated processing machine that installs electronic
components in the tinky winky. The new machine is an electronic fully automated
machine. The company has a tax rate of 40% and a required rate of return of 15%. Given
the following information, complete an NPV analysis and determine if the machine should
be replaced?
CAPITAL BUDGETING PROBLEMS

Existing Situation

Two full time machine operators at $35,000 per year

Maintenance costs $5,000 per year
Cost of defects $5,000 per year
Capital cost of old machine $60,000
Expected life 10 years
Machine’s age 7 years
Expected salvage $1,000
CCA rate 30%
Current market value $10,000

Proposed Replacement

Fully automated machine

Cost of machine $110,000
Installation and delivery costs $5,000
Cost of maintenance $6,000 per year
Cost of defects $2,000 per year
Expected life 3 years
Expected salvage value $21,000
The asset class will remain open at the end of the project.

7) Wave Interiors is considering the purchase of a new, fully automated machine to replace
an older, manually operated one. Both machines belong to an asset class with a CCA rate
of 20%. The old machine was purchased ten years ago for $40,000. The old machine can
be sold today for $15,000 or in five years for $3,000. It takes one employee to operate
the old machine, and he earns $15,000 per year in salary and $2,000 per year in
benefits. The annual cost of maintenance and repairs associated with the old machine were
$7,000 and $3,000 respectively. The replacement machine being considered has a
purchase price of $50,000 today and will have a $3,000 shipping fee and a $2,000
installation charge. The expected salvage value of this new machine is expected to be
$10,000 in five years. In addition, because the new machine would work faster than the
old one, investment in raw materials and goods-in –process inventories would need to be
increased by a total of $5,000. This increase in inventory cost will be recovered at the end
of the five-year project. The annual cost of maintenance and repairs on the new machine
would be $2,000 and $4,000 respectively. In order to purchase the new machine, it
appears the firm would have to borrow an additional $20,000 at 10 percent interest from
its local bank, resulting in additional interest payments of $2,000 per year. The
required rate of return on projects of this kind is 15% and the firm has an effective tax
rate of 45%.
a) Based on NPV analysis, should the firm replace the asset? Show your work.
b) What can you say about the IRR of the project? No calculations required.
c) What can you say about the PI of the project? No calculations required.

8) Aunt Sally’s Sauces Inc., is considering expanding into a new line of all-natural,
cholesterol-free, sodium free, fat free, low-calorie tomato sauces. Sally has paid $50,000
for a marketing study which indicates that the new product line would produce sales of
$650,000 per year for each of the next six years. The new equipment required to
CAPITAL BUDGETING PROBLEMS

produce the sauce would cost the company $500,000 and belongs to a class with a CCA
rate of 20%. The project will require an increase of $15,000 in cash and marketable
securities, an increase of $4,000 in receivables and an increase of $6,500 in inventory.
To finance part of the investment in current assets, accounts payable will have to increase
by $4,500. All investments in net working capital will be fully recovered at the end of the
useful life. Sally estimates that annual fixed costs will increase by $80,000 because of the
project and variable costs are projected at 40% of sales. The estimated salvage value of the
equipment is $125,000. Aunt Sally’s tax rate is 40% and the firm requires a 12% return
on capital budgeting projects.

a) Based on NPV analysis, should they accept or reject the project?

b) What can you say about the IRR of the project?

9) Flower Trends is a wholesale/retail flower distributor in Burnside. Management is

considering expanding into the PEI market. This expansion will require replacing some of
their existing refrigerated vehicles with more efficient ones. The existing vehicles were
purchased 3 years ago for $208,000 and have a remaining useful life of 4 years, at
which time it is estimated they will have a $12,000 salvage value. The current book value
is $39,800 but they are currently valued at $50,000 in the market. The new vehicles will
cost a total of $275,000. Management estimates that if the existing vehicles are replaced,
annual before-tax maintenance costs will decrease by $2500 and annual before tax
operating earnings will increase by $85,000. The vehicles belong to a CCA class that has a
rate of 25%. The new vehicles have a useful life of 4 years after which they can be sold for
$120,000. If the company expands, they will require an increase of $15,000 in cash and
marketable securities, an increase of $4,000 in receivables and an increase of $6,500 in
inventory. To finance part of the investment in current assets, accounts payable will have
to increase by $4,500. All investments in net working capital will be fully recovered at the
end of the useful life. Flower Trends will also have an additional expense of $5,000 for a
marketing survey that was completed a year ago. Assume Flower Trends has a cost of
capital of 12% and the firm has a 40% tax rate.

a) Based on NPV analysis, should Flower Trends expand into the PEI market?
Assume that the asset class remains open at the end of the project.
b) What can you say about the IRR of the project? Explain your answer.