Capital Budgeting Examples
Example 1
A company is considering the purchase of new equipment. The equipment costs $350,000, and
an additional $110,000 is needed to install it. The equipment will be depreciated straight-line to
zero over a five-year life. The equipment will generate additional annual revenues of $265,000,
and it will have annual cash operating expenses of $83,000. The equipment will be sold for
$85,000 after five years. An inventory investment of $73,000 is required during the life of the
investment. The company is in the 40 percent tax bracket and its cost of capital is 10 percent.
What is the project NPV?
Example 2
A company is considering replacing one of their machines used in the manufacturing process.
The machine was purchased 3 years ago for $100,000. This machine is being depreciated on a
straight-line basis, and it has 5 years of remaining life. When this machine was purchased 3 years
ago, it was assumed to have zero salvage value at the end of its useful life of 8 years. Currently,
the revenue generated by this machine is $30,000 annually and the cost of operating the machine
is $15,000 annually. The old machine can be sold at book value if replaced.
The replacement machine will cost of $125,000, an estimated useful life of 5 years, with zero
estimated salvage value. The replacement machine would permit an output expansion, so sales
would rise by $5,000 per year. Even so, the new machine's greater efficiency would cause
operating expenses to decline by $2000 per year. The new machine would require that
inventories be increased by $8,000, but accounts payable would simultaneously increase by
$3,000.
The company’s
marginal federal-plus-state tax rate is 40%, and its cost of capital is 12%.
Should the company replace the old machine?
