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BEC 3237 – Project Evaluation

THE EXPANSION OF THE WILLIAMS 5 & 10

The Williams 5 & 10 Company is a discount retail chain, selling a variety of goods at low prices. Business
has been very good lately, and the Williams 5 & 10 Company is considering opening one more retail outlet
in a neighboring town at the end of 1999. Management figures that it would be about five years before a
large national chain of discount stores moves into that town to compete with its store. So it is looking at
this expansion as a 5-year prospect. After five years, it would most likely retreat from this town.

Williams’ managers have researched the expansion and determined that the building needed could be
built for $400,000 and that it would cost $100,000 to buy the equipment. The building would be classified
as 31.5-year property and depreciated using the straight-line method, with no salvage value. This means
that ¹/₃₁.₅ of the $400,000 is depreciated each year. The equipment would be classified as 5-year property.
Management expects to be able to sell the building for $350,000, and the equipment for $50,000, after
five years.

The Williams 5 & 10 extends no credit on its sales and pays for all its purchases immediately. The
projections for sales and expenses for the new store for the next five years are:

The new store requires $50,000 of additional inventory. Since all sales are in cash, there is no expected
increase in accounts receivable. The tax rate is a flat 30%, and there are no tax credits associated with
this expansion. Also, capital gains are taxed at the ordinary tax rate.

(From- Capital Budgeting: Theory & Practice, Pamela P. Peterson & Frank J. Fabozzi (2002))
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Problem 02

THE REPLACEMENT OF FACILITIES AT THE HIRSHLEIFER COMPANY

The management of the Hirshleifer Company is evaluating the replacement of its existing manufacturing
equipment with a new equipment. The old equipment cost $200,000 five years ago, currently has a tax
basis of $100,000, and has been depreciated on the straight-line basis over a 10-year life, with no salvage
value. If Hirshleifer keeps the old equipment, it is expected it to last another five years, at which time the
10-year-old equipment is expected to be sold for $10,000. The old equipment could be sold today for
$120,000.

The new equipment costs $300,000 and is expected to have a useful life of five years. The new equipment
will be depreciated for tax purposes, using straight line method and a 5-year classified life. At the end of
its useful life, management expects to sell the new equipment for $100,000. Meanwhile, the new
equipment is expected to reduce production costs by $60,000 each year. In addition, since it is more
efficient, Hirshleifer can reduce its raw material and work-in-process inventories. Hirshleifer expects to
reduce its inventory by $10,000 as soon as the new equipment is placed in service. The income of
Hirshleifer is taxed at a rate of 35%. There are no tax credits available for this equipment. What cash flows
would result for each of the five years from this replacement?

(From- Capital Budgeting: Theory & Practice, Pamela P. Peterson & Frank J. Fabozzi (2002))
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Problem 03

The Delta Project

Delta Corporation is considering an investment proposal (the Delta Project), to expand one of its product
lines. The project is planned to start at the beginning of the year 2001 (denoted EOY 0, which in this case
is the end of 2000). Capital outlay in the first year is $1 million. At the end of year 3, another capital
expenditure of $0.5 million is required for an upgrade. The economic life of the project is estimated to be
eight years. The level of working capital for the project is tabulated below.

The salvage value of the total capital expenditure ($1.5 million) at the end of the eighth year is estimated
as $16,000. The depreciation rate for the initial investment, for tax purposes, is 12.5% per annum. The
upgrade depreciates at $100,000 per year for years 4 to 8. The forecast sales for the project are to be
based on a time-trend regression on the company’s last eleven years of sales, shown in Table 2.1

Forecast sales obtained from the time-trend regression are to be adjusted from year 4 onwards to account
for the increased sales resulting from the upgrade, which are estimated as 500,000 units per year. The
selling price of the product is expected to be 50 cents per unit for the first five years, and 75 cents
thereafter. The production cost is estimated to be 10 cents per unit. Other operating costs (which do not
include depreciation) are $50,000 per year for the first five years and $55,000 per year for the rest of the
project life. The corporate tax rate is 30%.

(From- Capital Budgeting- Financial Appraisal of Investment Projects, D. Dayananda, R. Irons, S. Harrison,
J. Herbohn, P. Rowland, (2002))
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Problem 04

The Repco Replacement Investment Project

Repco Corporation is considering a replacement investment. The machine currently in use was purchased
two years ago (in 1999) for $49,000. Depreciation for tax purposes is $9,800 per year for five years. The
market value of this machine today (at the beginning of year 2001) is $35,000. The new machine will cost
$123,000 and requires $3,000 for installation. Its economic life is estimated to be three years and tax-
allowable depreciation is $42,000 per year for three years. If the new machine is acquired, the investment
in accounts receivable is expected to rise by $8,000, the inventory by $25,000 and accounts payable by
$13,000. The annual income before depreciation and taxes is expected to be $65,000 for the next three
years (2001, 2002 and 2003) with the old machine, and $122,000, $135,000 and $130,000 for the 1st, 2nd
and 3rd years, respectively, with the new machine. The salvage values of the old and new machines three
years from today (end of 2003) is expected to be $3,500 and $4,000, respectively. The income tax rate is
25%. This income tax applies to operating income as well as to the book gains or losses on the machinery.
Book gain or loss is defined as the difference between market value and the tax book-value of the machine.
Book-value for taxation purposes is the original cost minus accumulated depreciation.

(From- Capital Budgeting- Financial Appraisal of Investment Projects, D. Dayananda, R. Irons, S. Harrison,
J. Herbohn, P. Rowland, (2002))