Capital Budgeting Problems:

Saving costs

 

Camus Blalack, process engineer, knew that the acceptance of a new process design would depend on its economic feasibility. The new process design required new equipment and an infusion of working capital. The equipment would cost $300,000 and its cash operating expenses would total $60,000 per year. The equipment would last for seven years but would need a major overhaul costing $30,000 at the end of the fifth year. At the end of seven years, the equipment would be sold for $24,000. An increase in working capital totaling $30,000 would also be needed at the beginning. This would be recovered at the end of the seven years.

 

On the benefit side, Camus estimated that the new process would save $135,000 per year in environmental costs (fines and cleanup costs avoided). The cost of capital is 10%. Ignore tax effects.

 

Is it beneficial to implement the new design process?

 

 

Additional revenue

Dr. Whitely Avard, plastic surgeon, had just returned from a conference during which she learned of a new surgical procedure for removing wrinkles around the eyes, reducing the time to perform the normal procedure by 50%. Given her student loan pressures, Dr. Avard was anxious to try out the new technique. By decreasing the time spent on eye treatments or procedures, she could increase her total revenues by performing more services within a work period. Unfortunately, in order to implement the new procedure, some special equipment costing $74,000 was needed. The equipment had an expected life of four years, with a salvage value of $6,000. Dr. Avard estimated that her case revenues would increase by the following amounts:

 

                                         Year                                       Revenue

$19,800

$27,000

$32,400

$32,400

      She also expected additional case expenses amounting to $3,000 per years. The cost of capital is 12%. Assume there are no income taxes.

Should Dr. Avard buy the machine?

Lease vs. Buy

 

Trasky Company is trying to decide whether it should purchase or lease a new automated machine to be used in the production of a new product. If purchased, the new machine would cost $100,000 and would be used for ten years. The salvage value at the end of ten years is estimated at $20,000. The machine would be depreciated using MACRS over a seven year period. The annual maintenance and operating costs would be $20,000. Annual revenues are estimated at $55,000.

 

If the machine is leased, the company would need to pay annual lease payments of $20,700. The first lease payment and a deposit of $5,000 are due immediately. The last lease payment is paid at the beginning of Year 10. The deposit is refundable at the end of the tenth year. In additional, under a normal contract, the company must pay for all maintenance and operating costs, although the leasing company does offer a service contract that will provide annual maintenance (on leased machines only). The contract must be paid up front and costs $30,000. Trasky estimates that the contract will reduce its annual maintenance and operating costs by $10,000. TraskyAc€?cs cost of capital is 14%. The tax rate is 40%. The service contractAc€?cs costs would e expensed over the 10 year period. Assume this is an operating lease.

 

Calculate the NPV for the purchase, lease without the service contract, and the lease with the service contract.

Which is the best alternative?