HOMEWORK

Capital Budgeting

Students Name

Institution of Affiliation

Date

Question 1

The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $9 million (the existing equipment has zero salvage value). The attraction of the new machinery is that it is expected to cut manufacturing costs from their current level of $8 a welt to $4. However, as the following table shows, there is some uncertainty both about future sales and about the performance of the new machinery:

	Pessimistic	Expected	Optimistic
Sales, millions of welts	0.4	0.5	0.7
Manufacturing cost with new machinery, dollars per welt	6	4	3
Economic life of new machinery, years	7	10	13

Calculate the annual cost savings of the expected scenario under the three states of nature. Assume a discount rate of 12%. RW does not pay taxes.

Answer

If the company replaces its old welt making machinery with the modern equipment it will incurs $9 million investment on capital. Also, the companies’ manufacturing costs will decrease and the economic life will run for 10 years.

Incremental difference is what is relevant to decision making, for the cost saving, the difference is incremental as shown above, we assume the cost saving is an annuity hence discounted as PVAF

Pessimistic case

Cost saving per welt= $8-$6= $2

Total cost saving per annum= 0.4*$2

=$0.8

Depreciation $9-0/7

$1.29

Net cost saving =0.8-1.29

=-0.49M

PV of net cost saving = -0.49MPVIF12%/7years

= -0.49*0.4817

=-0.236M

Optimistic case

Cost saving per welt= 8-3

=5

Total cost saving per year= 0.7*5 =

=3.5

Depreciation = 9-0/13

0.6923

Net cost saving= 3.5 -0.6923

2.8077

PV of net cost saving = 2.8077*PVIF 12%/13 years

$0.6435

RW Co.

New equipment existing equipment

Cost $9M salvage value= 0

Manufacturing cost $4M Manufacturing cost $8M

Economic life= 10yrs

Annual cost =$p/PVIF at 12%. 10years

=1.5929

Cost saving per welt = 8-4= 4

Total cost saving per year= 0.5 * $4M =2M for the expected case

Depreciation 9-0//10 =0.9

Net cost saving =2m-0.9m=1.1

PV of net cost saving = 1.1M * PVIF 12%.10 years

=0.3542

Question 2

You are the judge in a settlement case. You need to compute the value of a piece of land in Denver Co. The valuation is subject to the following conditions 

1. The settlement will take place at the end of 2019 

2. The current appraised value of the land on 1/1/2018 is $500.000 

3. The piece of land has a building on it that is uninhabitable. It takes one year to bring the building down at a cost of $100,000. That money must be paid now. 

4. The land can be rented in 2019 at a net proceeds of 40,000 

5. While rented the land cost $20,000 in property taxes 

6. Your real estate adviser notes that selling prices of comparable lands in Denver have declined, in real terms, at an average rate of 3% per year over the last 5 years. 

7. The cost of capital is 10% 

8. The sale of the land at the end of 2019 is subject to a 10 % commission. 

What should someone pay today for this land if given the choice?

Answer

The PV of the land will be computed towards end of 2019

Add the PV of the net gains from sale of land

Less PV of sale commission

Less PV of expenses

The worth of land towards end of 2019 for 2 years decreasing b 3%

= 500000*(1-3%)2

= 470,450

Calculating the PV today for the land we find

FV/(1+C)n = 470450/(1+10%)2

Where C is the cost of capital

= 388,802

Net gains towards the end of 2019 we find

Land Rent -Taxes

= 40000 – 20000

= 20000

PV of the gains today

= FV /(1+C)n = 20000/(1+10%)2

= 16,529

Calculating commissions from land sale in 2018

= 10%* 470,450

= 47045

PV from commission today

FV/(1+C)n = 47045/(1+10%)2

= 38,880

PV of expenses

= 100,000

Net value

= 388802 + 16529 - 38880 - 100000 = $ 266,451

References

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.