You are an external capital budgeting advisor to a highly successful manufacturing firm. You have recently received a proposal for equipment replacement that will presumably lead to more capacity and less cost. The replacement details are given below.
Old Equipment New Equipment
Current book value $ 400,000
Current market value $ 600,000 Acquisition cost $ 1,000,000
Remaining life (yrs.) 10 Life (yrs.) 10
Annual sales $ 300,000 Annual sales $ 450,000
Cash operating expenses $ 120,000 Cash operating expenses $ 150,000
Annual depreciation $ 40,000 Annual depreciation $ 100,000
Accounting salvage value $ 0 Accounting salvage value $ 0
Expected salvage value $ 100,000 Expected salvage value $ 200,000
If the new equipment replaces the old equipment, an additional investment of $80,000 in net working capital will be required. The tax rate is 30% and the required rate of return is 10%.
As you work through the NPV and IRR analysis provided by the company, you discover the following errors:
• The initial outlay correctly accounts for incremental investment in new fixed capital and net working capital but after-tax cash proceeds from the sale of old fixed capital are not adjusted.
• Annual operating cashflows are not adjusted for tax and depreciation is not added back.
• Terminal-year after-tax non-operating cashflows do not recapture investment in net working capital. Also, incremental capital gains on salvage value are not taxed.
You realise that you need to do the entire project feasibility report from scratch. You set out to do the following:
(a) Calculate the initial outlay, year on year after-tax operating cash flows, and terminal-year after-tax non-operating cashflow for the old and new equipment.
(b) Present these cash flows in a tabular format indicating the relevant year in which these cash flows fall. You believe the usage of a spreadsheet will be very helpful for this exercise.
(c) Find out the NPV, IRR, and Profitability Index for the replacement proposal.
(d) Conduct a sensitivity analysis of NPV to the required rate of return falling between the range of 10% to 16% pa (with increments of 1%).
(e) Tabulate your results. This step is required because there are some uncertainties at the top management level regarding the appropriate required rate of return to be used due to substantial decrease in risk-free rate over the years.
(f) Following the AIB assignment format, prepare an advisory report for the management that includes:
• a theoretical background to the three investment decision criteria you have used for analyses
• a comparison among these methodologies
• a note on why these criteria are superior to accounting rate of return and payback period used by some firms
• an analysis of the problem at hand and specific recommendations on the proposal, which integrates all the calculations and tabulations made in (a) to (d) above.