CAPITAL BUDGETING Shenandoah Furniture, Inc.

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1 CAPITAL BUDGETING Shenandoah Furniture, Inc. Shenandoah Furniture is considering replacing one of the machines in its manufacturing facility. The cost of the new machine will be $76,120. Transportation will cost an additional $2,500 and the new machine will increase the need for working capital by $1,400. The new asset will be depreciated using the MACRS technique over a 5 year period. The company expects to dispose of the machine in 6 years. The expected salvage value for the machine at that time is $2,300. The savings (before depreciation and taxes) that are associated with the new and old machines are expected to be as follows: New Asset Old Asset Year 1 $28,000 Year 1 $2,000 Year 2 25,000 Year 2 2,000 Year 3 19,000 Year 3 2,000 Year 4 16,000 Year 4 2,000 Year 5 14,000 Year 5 2,000 Year 6 5,000 Year 6 2,000 The old machine (the one being replaced) is now 4 years old and can be sold today for $14,300. When originally purchased, this machine cost $54,600. If kept, the scrap value of the old machine will be zero in 6 more years. The accumulated depreciation on the old asset is currently $45,154. (The depreciable life for the machine is the same as for the new machine: five years.) The hurdle rate for the company is 12%. The firm is in the 34% tax bracket. Using the various evaluation methods for capital budgeting (e.g. net present value method and the internal rate of return method), determine whether or not the firm should purchase the new asset.

2 Solution To Shenandoah Furniture Capital Budgeting Problem Since depreciation is a tax deductible item, it affects the amount of the savings that we get to keep (after the government takes its cut). So we first need to calculate what the change in depreciation will be if we decide to buy the new equipment. Depreciation on the New Asset (Depreciable Cost = $78,620) MACRS Value: Depreciation: Year Year 1 $15,724 Year Year 2 25,158 Year Year 3 15,095 Year Year 4 9,041 Year Year 5 9,041 Year Year 6 4,560 Unused Depreciation on the Old Asset: (Depreciable Cost = $54,600) MACRS Value Depreciation: Year Year 1 0 Year Year 2 0 Year Year 3 0 Year Year 4 0 Year Year 5 6,279 Year Year 6 3,167 Calculation of the Change in Depreciation (Needed For Determination of Cash Inflows) New - Old = Increase Next Year = $15,724 - $6,279 = $9,445 Year 2 = 25,158-3,167 = 21,992 Year 3 = 15,095-0 = 15,095 Year 4 = 9,041-0 = 9,041 Year 5 = 9,041-0 = 9,041 Year 6 = 4,560-0 = 4,560

3 Determination of Cash Inflows Now that we know the change in depreciation, we can calculate the amount of money that the company will get to keep from its net savings (i.e., the cash inflow for each year). Yr. Net Savings x (1-t.r.) + Chg. in Deprec. x Tax Rate = Cash Inflow* 1 26,000 x ,445 x 0.34 = $20, ,000 x ,992 x 0.34 = 22, ,000 x ,095 x 0.34 = 16, ,000 x ,041 x 0.34 = 12, ,000 x ,041 x 0.34 = 10, ,000 x ,560 x 0.34 = 3,530 * Does Not Include These Terminal Cash Flows: Working Capital = $1,400 (Cash Inflow) + Salvage Value = 2,300 (Cash Inflow) - Tax on Salvage Value = 782 (Cash Outflow) Total Terminal Cash Flows = $2,918 (Cash Inflow) Net Present Value of the Project We are now ready to test whether the equipment will be profitable for us (i.e., whether it will return our investment, our financing cost, and a profit large enough to compensate us for accepting the risk in the project). CASH 12% CASH INFLOWS (0) Cost of Asset $76,120 (1) $20,371 x = $18,192 Transportation 2,500 (2) 22,657 x = 18,058 Working Capital 1,400 (3) 16,352 x = 11,643 Sale Proceeds (14,300) (4) 12,314 x = 7,832 Tax on Sale of Old 1,650 (5) 10,994 x = 6,234 (6) 6,448 x = 3,269 P.V. of Costs = $67,370 P.V. of Benefits = $65,227 where the tax on the sale of the old asset is: Net Present Value = ($2,143) Step #1: Original Cost $54,600 Step #2: Selling Price $14,300 - Accum. Deprec. - 45,154 - Book Value - 9,446 Book Value $ 9,446 Gain (Loss) $4,854 Step #3: Gain (or Loss) $4,854 x Tax Rate x 0.34 Tax on Sale of Old Asset $1,650

4 Internal Return (IRR) Now for the profitability expressed as a percent (rather than in dollars) the internal rate of return: 1% (outside difference) X (difference on top) 10% 68,388 1,017 (difference on top) I.R.R. 67,370 1,598 (outside difference) 11% 66,790 X 1% = 1,017 1,598 X = 1,017 1,598 * 1% X = 0.64% The I.R.R. is 10.64%. Modified internal rate of return (MIRR) CASH 12% CASH INFLOWS (0) Cost of Asset $76,120 (1) $20,371 x = $35,901 Transportation 2,500 (2) 22,657 x = 35,651 Working Capital 1,400 (3) 16,352 x = 22,974 Sale Proceeds (14,300) (4) 12,314 x = 15,447 Tax on Sale of Old 1,650 (5) 10,994 x = 12,313 (6) 6,448 x = 6,448 P.V. of Costs = $67,370 F.V. of Benefits = $128,735 If the project costs $67,370 today and it generates cash of $128,735 after six years, what is the project s rate of return? We use the geometric mean return formula to solve for the rate of return: Ending value return n Beginning value return 6 $128,735 $67,370 return return ( ) return or11.40%

5 Year Cash Outflow Calculation of Payback Period Cash Inflow Amount Owed No. of Years 0 67,370 67, ,371 46, ,657 24, ,352 7, , , , Payback Period = 3.65 years Summary of Capital Budgeting Measures Method Conclusion Net Present Value = ($2,143) Reject the project: negative NPV Profitability Index = 0.97 Reject the project: less than 1.00 Modified IRR = 11.40% Reject the project: less than hurdle rate Internal Return = 10.64% Reject the project: less than hurdle rate Payback Period (years) = 3.65 Reject if required payback is <3.65 years