13 - 1

The Basics of Capital Budgeting:

Evaluating Cash Flows
Should we
build this
plant?
 13 - 2
Capital Budgeting

 Capital Budgeting is the process of determining which

real investment projects should be accepted and given
an allocation of funds from the firm.

 To evaluate capital budgeting processes, their

consistency with the goal of shareholder wealth
maximization is of utmost importance.
 13 - 3
Nature of Investment Decisions
 The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.
 The firm’s investment decisions would generally
include expansion, acquisition, modernisation
and replacement of the long-term assets. Sale of a
division or business (divestment) is also as an
investment decision.
 Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-
term implications for the firm’s expenditures and
benefits, and therefore, they should also be
evaluated as investment decisions.

3
 13 - 4

What is capital budgeting?

 Analysis of potential additions to

fixed assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
 13 - 5
Recall the Flows of funds and decisions
important to the financial manager

Investment Financing
Decision Decision

Reinvestment Refinancing
Real Assets Financial Financial
Manager Markets

Returns from Investment Returns to Security Holders

 13 - 6
Features of Investment Decisions

 The exchange of current funds for

future benefits.
 The funds are invested in long-term
assets.
 The future benefits will occur to the
firm over a series of years.

6
 13 - 7

Importance of Investment Decisions

 Growth  
 Risk 
 Funding  
 Irreversibility
 Complexity  

7
 13 - 8
Investment Evaluation Criteria

 Three steps are involved in the

evaluation of an investment:
 Estimation of cash flows
 Estimation of the required rate of return (the
opportunity cost of capital)
 Application of a decision rule for making the
choice

8
 13 - 9
Investment Decision Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true
profitability of the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true
profitability.
 It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are preferable
to later ones.
 It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable
investment project independent of others by reflecting its risk.

9
 13 - 10
Evaluation Criteria

 1. Discounted Cash Flow (DCF) Criteria

   Net Present Value (NPV)
   Internal Rate of Return (IRR)
   Profitability Index (PI)

 2. Non-discounted Cash Flow Criteria

   Payback Period (PB)
   Discounted Payback Period (DPB)
   Accounting Rate of Return (ARR)

10
 13 - 11
First Principles
 Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
 The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money
(debt)
 Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches
the assets being financed.
 If there are not enough investments that earn the hurdle rate, return
the cash to stockholders.
 The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics.
 13 - 12

Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
 Discounted Cash Flow (DCF)
13 - 13

Techniques
 The main DCF techniques for capital budgeting include: Net Present
Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI)
 Each requires estimates of expected cash flows (and their timing) for
the project.
• Including cash outflows (costs) and inflows (revenues or savings) –
normally tax effects are also considered.
 Each requires an estimate of the project’s risk so that an appropriate
discount rate (opportunity cost of capital) can be determined.
• The discussion of risk will be deferred until later. For now, we will assume
we know the relevant opportunity cost of capital or discount rate.
 Sometimes the above data is difficult to obtain – this is the main
weakness of all DCF techniques.
 13 - 14
What is the difference between
independent and mutually exclusive
projects?

Projects are:
independent, if the cash flows of
one are unaffected by the
acceptance of the other.
mutually exclusive, if the cash flows
of one can be adversely impacted
by the acceptance of the other.
 13 - 15

An Example of Mutually Exclusive

Projects

BRIDGE vs. BOAT to get

products across a river.
 13 - 16
Normal Cash Flow Project:
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power plant, strip mine.
 13 - 17

Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
 13 - 18

What is the payback period?

The number of years required to

recover a project’s cost,

or how long does it take to get the

business’s money back?
 13 - 19

Payback for Project L

(Long: Most CFs in out years)

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

 13 - 20

Project S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

 13 - 21
Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
 Evaluation of Payback 13 - 22
 Certain virtues:
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity

 Serious limitations:
 Cash flows after payback
 Cash flows ignored
 Cash flow patterns
 Administrative difficulties
 Inconsistent with shareholder value

22
 13 - 23

Discounted Payback: Uses discounted

rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

 13 - 24

NPV: Sum of the PVs of inflows and

outflows.
n CFt
NPV   .
t  0 1  k 
t

Cost often is CF0 and is negative.

n
CFt
NPV    CF0 .
t 1 1 k t
 13 - 25

What’s Project L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
 13 - 26

Calculator Solution

Enter in CFLO for L:

-100 CF0

10 CF1

60 CF2

80 CF3

10 I NPV = 18.78 = NPVL

 13 - 27

Rationale for the NPV Method

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
 13 - 28

Using NPV method, which project(s)

should be accepted?

 If Projects S and L are mutually

exclusive, accept S because
NPVs > NPVL .
 If S & L are independent,
accept both; NPV > 0.
 Evaluation of the NPV Method
13 - 29

 NPV is most acceptable investment rule for

the following reasons:
 Time value
 Measure of true profitability
 Value- additivity
 Shareholder value

 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 Mutually exclusive projects
 Ranking of projects

29
 13 - 30

Profitability Index
 Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial
cash outflow of the investment.

30
 13 - 31
Profitability Index
 The initial cash outlay of a project is Rs
100,000 and it can generate cash inflow of Rs
40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in
year 1 through 4. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per
cent discount rate is:

PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )

= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV  Rs 112,350  Rs 100,000 = Rs 12,350
Rs 1,12,350
PI   1.1235.
Rs 1,00,000

31
 13 - 32
Acceptance Rule
 The following are the PI acceptance rules:
 Accept the project when PI is greater than one. PI >
1
 Reject the project when PI is less than one. PI
<1
 May accept the project when PI is equal to one. PI =
1

 The project with positive NPV will have PI

greater than one. PI less than means that
the project’s NPV is negative.

32
 13 - 33
Evaluation of PI Method

 It recognises the time value of money.

 It is consistent with the shareholder value
maximisation principle. A project with PI greater than
one will have positive NPV and if accepted, it will
increase shareholders’ wealth.
 In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a project’s profitability.
 Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash flows
and discount rate pose problems.

33
 NPV Versus PI 13 - 34

 A conflict may arise between the two

methods if a choice between mutually
exclusive projects has to be made.
Follow NPV method:

Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50

34
 13 - 35

Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
 13 - 36

NPV: Enter k, solve for NPV.

n CFt
  NPV.
t  0 1  k 
t

IRR: Enter NPV = 0, solve for IRR.

n CFt
  0.
t  0 1  IRR
t
 13 - 37

What’s Project L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
 13 - 38
Find IRR if CFs are constant:
0 1 2 3
IRR = ?

-100 40 40 40

INPUTS 3 -100 40 0
N I/YR PV PMT FV
OUTPUT 9.70%

Or, with CFLO, enter CFs and press

IRR = 9.70%.
 13 - 39
Q. How is a project’s IRR
related to a bond’s YTM?
A. They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.

0 1 2 10
IRR = ? ...
-1,134.2 90 90 1,090

IRR = 7.08% (use TVM or CFLO).

 13 - 40

Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
 13 - 41

IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

 13 - 42

Decisions on Projects S and L per IRR

 If S and L are independent, accept

both. IRRs > k = 10%.
 If S and L are mutually exclusive,
accept S because IRRS > IRRL .
 13 - 43

Construct NPV Profiles

Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:
k NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5
 13 - 44
NPV ($) NPVL NPVS
k
60
0 50 40
50 5 33 29
40
Crossover 10 19 20
Point = 8.7% 7 12
15
30
20 (4) 5
20
S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
 13 - 45
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

k (%)
IRR
 13 - 46

Mutually Exclusive Projects

NPV k < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

k 8.7 k %
IRRL
 13 - 47

To Find the Crossover Rate

1. Find cash flow differences between the

projects. See data at beginning of the
case.
2. Enter these differences in CFLO register,
then press IRR. Crossover rate = 8.68%,
rounded to 8.7%.
3. Can subtract S from L or vice versa, but
better to have first CF negative.
4. If profiles don’t cross, one project
dominates the other.
 13 - 48

Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smaller

project frees up funds at t = 0 for
investment. The higher the opportunity
cost, the more valuable these funds, so
high k favors small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If k is high,
early CF especially good, NPVS > NPVL.
 13 - 49
NPV Vs IRR

 The NPV and IRR rules give conflicting ranking to

the projects under the following conditions:
 The cash flow pattern of the projects may differ. That is,
the cash flows of one project may increase over time,
while those of others may decrease or vice-versa.
 The cash outlays of the projects may differ.
 The projects may have different expected lives.

49
 13 - 50

Timing of Cash Flows  

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%

50
 13 - 51

Scale of Investment  

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%

51
 13 - 52

Project Life Span  

Cash Flows (Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

X – 10,000 12,000 – – – – 908 20%

Y – 10,000 0 0 0 0 20,120 2,495 15%

52
 13 - 53

Reinvestment Assumption

 The IRR method is assumed to imply

that the cash flows generated by the
project can be reinvested at its internal
rate of return, whereas the NPV
method is thought to assume that the
cash flows are reinvested at the
opportunity cost of capital.

53
 13 - 54

Reinvestment Rate Assumptions

 NPV assumes reinvest at k (opportunity

cost of capital).
 IRR assumes reinvest at IRR.
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.
 13 - 55

Multiple IRR

0 1 2
k = 10%

-800 5,000 -5,000

Enter CFs in CFLO, enter I = 10.

NPV = -386.78
IRR = ERROR. Why?
 13 - 56
We got IRR = ERROR because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
 13 - 57

Logic of Multiple IRRs

1. At very low discount rates, the PV of

CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
3. In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
 13 - 58
Evaluation of IRR Method

 IRR method has following merits:

 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

 IRR method may suffer from:

 Multiple rates
 Mutually exclusive projects (Conflict with NPV)
 Value additivity

58
 13 - 59

Managers like rates--prefer IRR to NPV

comparisons. Can we give them a
better IRR?
Yes, MIRR is the discount rate which
causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.

Thus, MIRR assumes cash inflows are

reinvested at WACC.
 13 - 60

MIRR for Project L (k = 10%)

0 1 2 3
10%

-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
MIRR =
158.1
16.5%
-100.0 $158.1 TV inflows
$100 =
(1+MIRRL)3
PV outflows
MIRRL = 16.5%
 13 - 61

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
Managers like rate of return
comparisons, and MIRR is better for
this than IRR.
 13 - 62

When there are nonnormal CFs and

more than one IRR, use MIRR:

0 1 2

-800,000 5,000,000 -5,000,000

PV outflows @ 10% = -4,932,231.40.

TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
 13 - 63

Accept Project P?

NO. Reject because MIRR =

5.6% < k = 10%.

Also, if MIRR < k, NPV will be

negative: NPV = -$386,777.
 13 - 64

S and L are mutually exclusive and

will be repeated. k = 10%. Which is
better? (000s)

0 1 2 3 4

Project S:
(100) 60 60
Project L:
(100) 33.5 33.5 33.5 33.5
 13 - 65

S L
CF0 -100,000 -100,000
CF1 60,000 33,500
Nj 2 4
I 10 10

NPV 4,132 6,190

NPVL > NPVS. But is L better?
Can’t say yet. Need to perform
common life analysis.
 13 - 66

 Note that Project S could be

repeated after 2 years to generate
additional profits.
 Can use either replacement chain
or equivalent annual annuity
analysis to make decision.
 13 - 67

Replacement Chain Approach (000s)

Project S with Replication:

0 1 2 3 4

Project S:
(100) 60 60
(100) 60 60
(100) 60 (40) 60 60

NPV = $7,547.
 13 - 68

Or, use NPVs:

0 1 2 3 4

4,132 4,132
3,415 10%
7,547

Compare to Project L NPV = $6,190.

 13 - 69

If the cost to repeat S in two years rises

to $105,000, which is best? (000s)

0 1 2 3 4

Project S:
(100) 60 60
(105) 60 60
(45)

NPVS = $3,415 < NPVL = $6,190.

Now choose L.
 13 - 70
Annual Equivalent Value (AEV) Method
 The method for handling the choice of the
mutually exclusive projects with different
lives, as discussed in last slide, can become
quite cumbersome if the projects’ lives are
very long.
 We can calculate the annual equivalent
value (AEV) of cash flows of each project.
We shall select the project that has higher
annual equivalent AEV of cash inflows or lower
AEV of cost.
NPV
AEV 
Annuity factor

70
 13 - 71

Consider another project with a 3-year

life. If terminated prior to Year 3, the
machinery will have positive salvage
value.

Year CF Salvage Value

0 ($5,000) $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0
 13 - 72

CFs Under Each Alternative (000s)

0 1 2 3
1. No termination (5) 2.1 2 1.75
2. Terminate 2 years (5) 2.1 4
3. Terminate 1 year (5) 5.2
 13 - 73

Physical Life Vs Economic Life

Assuming a 10% cost of capital, what is

the project’s optimal, or economic life?

NPV(no(3yrs)) = -$123.
NPV(2 yrs) = $215.
NPV(1 yrs) = -$273.
 13 - 74

Conclusions

 The project is acceptable only if

operated for 2 years.
 A project’s engineering life does not
always equal its economic life.
 13 - 75

Choosing the Optimal Capital Budget

 Finance theory says to accept all positive

NPV projects.
 Two problems can occur when there is not
enough internally generated cash to fund
all positive NPV projects:
An increasing marginal cost of
capital.
Capital rationing
 13 - 76

Increasing Marginal Cost of Capital

 Externally raised capital can have

large flotation costs, which increase
the cost of capital.
 Investors often perceive large capital
budgets as being risky, which drives
up the cost of capital.
(More...)
 13 - 77

 If external funds will be raised, then

the NPV of all projects should be
estimated using this higher marginal
cost of capital.
13 - 78
 13 - 79
Complex Investment Problems

 How shall choice be made between

investments with different lives?
 Should a firm make investment now,
or should it wait and invest later?
 When should an existing asset be
replaced?
 How shall choice be made between
investments under capital rationing?

79
 13 - 80

Projects with Different Lives

 The choice between projects with
different lives should be made by
evaluating them for equal periods of
time.
Cash Outflows (Rs 000)
0 1 2 3 4 NPV, 10%
Y1 60 40 40 0 0 129.42

Y2 0 0 60 40 40 106.96

Y = Y1 + Y2 60 40 100 40 40 236.38

X 120 30 30 30 30 215.10

80
 13 - 81
Annual Equivalent Value (AEV) Method
 The method for handling the choice of
the mutually exclusive projects with
different lives, as discussed in last
slide, can become quite cumbersome if
the projects’ lives are very long.
 We can calculate the annual equivalent
value (AEV) of cash flows of each
project. We shall select the project that
has lower annual equivalent cost.

NPV
AEV 
Annuity factor
81
 13 - 82
AEV for Perpetuities
 When we assume that projects can be
replicated at constant scale indefinitely, we
imply that an annuity is paid at the end of
every n years starting from the first period.

 (1  k ) n 
NPV  (NPVn )   
 (1  k ) n
 1 
 where NPV is the present value of the
investment indefinitely, NPVn is the present
value of the investment for the original life,
n and k is the opportunity cost of capital.

82
 13 - 83

Replacement of an Existing Asset

 Compare the annual
equivalent value (AEV) of
the old and new
equipment as given Equipment C0 C1 C2 C3 C4 C5 NPV at
below.
12%
 It is indicated that a chain
of new machines is New –12 6 6 6 6 6 9.63
equivalent to an annuity Old – 4 3 2 – – 7.39
of Rs 9,630  3.605 = Rs AEV, New – 2.67 2.67 2.67 2.67 2.67 9.63
2,671 a year for the life of
the chain. The existing AEV, Old – 3.08 3.08 3.08 – – 7.39
machine is still capable of
providing an annuity of:
Rs 7,390  2.402 = Rs
3,076. So long as the
existing machine
generates a cash inflow of
more than Rs 2,671 there
does not seem to be an
economic justification for
replacing it.

83
 13 - 84

Investment Timing and Duration

 The rule is
straightforward:
undertake the
project at that Project
point of time, Undertaken NPV

at Period
which 0
1
–100 + 150  0.909
–120  0.909 + 180  0.826
= 36.35
= 39.60
maximizes the 2 –140  0.826 + 205  0.751 = 38.32

NPV.

84
 13 - 85
Investment Decisions Under Capital
Rationing
 Capital rationing refers to a situation
where the firm is constrained for external,
or self-imposed, reasons to obtain
necessary funds to invest in all
investment projects with positive NPV.
Under capital rationing, the management
has not simply to determine the profitable
investment opportunities, but it has also
to decide to obtain that combination of the
profitable projects which yields highest
NPV within the available funds.

85
 13 - 86

Why Capital Rationing

 There are two types of capital
rationing:
  External capital rationing.
  Internal capital rationing.

86
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Profitability Index
 The NPV rule should be modified while
choosing among projects under capital
constraint. The objective should be to
maximise NPV per rupee of capital rather
than to maximise NPV. Projects should be
ranked by their profitability index, and top-
ranked projects should be undertaken until
funds are exhausted.

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Capital Rationing

 Capital rationing occurs when a

company chooses not to fund all
positive NPV projects.
 The company typically sets an
upper limit on the total amount
of capital expenditures that it will
make in the upcoming year.
(More...)
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Reason: Companies want to avoid the

direct costs (i.e., flotation costs) and
the indirect costs of issuing new
capital.
Solution: Increase the cost of capital
by enough to reflect all of these costs,
and then accept all projects that still
have a positive NPV with the higher
cost of capital.
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Reason: Companies don’t have

enough managerial, marketing, or
engineering staff to implement all
positive NPV projects.

Solution: Use linear programming to

maximize NPV subject to not
exceeding the constraints on staffing.
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Reason: Companies believe that the

project’s managers forecast
unreasonably high cash flow estimates,
so companies “filter” out the worst
projects by limiting the total amount of
projects that can be accepted.
Solution: Implement a post-audit
process and tie the managers’
compensation to the subsequent
performance of the project.
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Capital Budgeting of RIC

 RIC’s R & D department has been applying its
expertise in microprocessor technology to develop
a small computer designed to control home
appliances. Once programmed, the computer will
automatically control the heating and air-
conditioning systems, security system, hot water
heater, and even small appliances such as a coffee
maker. Developments have now reached the stage
where a decision must be made about whether or
not to go forward with full-scale production. The
cost incurred for R&D was $ 80,000.
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RIC’s marketing vice-president believes that annual sales
would be 20,000 units if the units were priced at $3,000
each. RIC expects no growth in sales, and it believes that
the unit price will rise by 2 percent each year. The
engineering department has reported that the project will
require additional manufacturing space, and RIC currently
has an option to purchase an existing building , at a cost of
$12 millions, which would meet this need. The building will
be purchased at December 31, 2017 and it falls into MACRS
10-year class.
The necessary equipment would be purchased and installed in
late 2017, and it would also be paid for on December 31,
2017. The equipment would fall into the MACRS 5-year
class, and it would cost $7.8 million and the transportation
and installation charges will amount to $0.2 million.
The project’s estimated economic life is four years. At the end
of the time, the building is expected to have a market value
of $7.5 million, whereas the equipment would have a market
value of $2 million.
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The production department has estimated that variable
manufacturing costs would be $2,100 per unit, and that
fixed overhead costs, excluding depreciation, would be $8
million a year. They expect variable costs to rise by 2
percent per year, and fixed costs to rise by 1 percent per
year. RIC must have an amount of net working capital on
hand equal to 10 percent of the upcoming year’s sales.
RIC’s marginal tax rate is 40 percent; its cost of capital is 12
percent. The sales of the computer will also increase the
sales of the operating system developed by RIC which is
estimated to be $2 million per year.
Should the project be undertaken?