Capital Budgeting Case, Spring 2016 In December of 20X1, Balloon Popper Inc. was
ID: 2472299 • Letter: C
Question
Capital Budgeting Case, Spring 2016 In December of 20X1, Balloon Popper Inc. was trying to decide whether to add a new line of super strong balloons to its product line. In order to do this, it would need to buy a new silicone pouring machine (cost below). Sales for the new balloons were expected to be $2000000 per year from which sales commissions were to be paid to Balloon Poppers sales agents (see below). Direct manufacturing costs were budgeted at $600,000 for materials, and $900,000 for labor. The new equipment would (cost below) will have a disposal value of $50,000. Sales Commissions 5% Economic life 5 Cost of Capital 7% Initial Cost 1500000 1. Ignoring taxes, what is the IRR of the project? What is the NPV of the new project? Assume the machinery will be installed on January 1 of 20x1 and be depreciated using the straight line method. (it is easiest to calculate IRR using Excel) 2. Assuming a 40% tax rate, and that according to the IRS this is a 5-year asset (MACRS rates for Yr 1 .2, YR 2 .32, YR 3 .192, YR 4 .115, Y5 5 .115, YR 6 .058), what is the IRR? What is the NPV? 3. To stimulate industrial development, the tax rules allow 60% of the asset cost to be deducted the first year, with the remaining f the asset cost to be deducted equally over the remaining 4 years (since it is considered to be a 5-year asset). What is the IRR, what is the NPV? 4. If Balloon Popper requires a 12 % return on all new investments, should they take on this investment? 5. What is the payback period? 6. What is the accounting rate of return? 7. Do you believe you should invest in the project? Why? Please show all work.
Explanation / Answer
New Machine Annual net Income Amt $ Sales 2,000,000 Less Variable costs Direct Materials (600,000) Direct Labor (900,000) Sales commission (100,000) Net Income per annum 400,000 NPV /IRR calculation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 1 Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 net Cash Flow (1,500,000) 400,000 400,000 400,000 400,000 450,000 PV factor @7% 1 0.935 0.873 0.816 0.763 0.713 PV of Cash flows (1,500,000) 373,832 349,375 326,519 305,158 320,844 NPV = 175,728 IRR calculation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 net Cash Flow (1,500,000) 400,000 400,000 400,000 400,000 450,000 PV factor @11.21% 1 0.899 0.809 0.727 0.654 0.588 PV of Cash flows (1,500,000) 359,680 323,424 290,823 261,508 264,541 NPV = (24) So at required return rate 11.21% the NPV is close to 0. So IRR =11.21% 2 When Tax arte is 40% NPV /IRR calculation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 MACRS rate 20.00% 32.00% 19.20% 11.50% 11.50% Book value after yr 5= 87,000 Salvage value = 50,000 Capital Loss 37,000 Tax benefiot on captal loss 14,800 Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 Depreciation (300,000) (480,000) (288,000) (172,500) (172,500) Taxable income 100,000 (80,000) 112,000 227,500 227,500 Tax @40% (40,000) 32,000 (44,800) (91,000) (91,000) Tax benefit of capital loss 14,800 Net Post Tax Income (including Salvage ) 60,000 (48,000) 67,200 136,500 201,300 Add Back depreciation 300,000 480,000 288,000 172,500 172,500 net Cash Flow (1,500,000) 360,000 432,000 355,200 309,000 373,800 PV factor @7% 1 0.935 0.873 0.816 0.763 0.713 PV of Cash flows (1,500,000) 336,449 377,326 289,949 235,735 266,514 NPV = $ 5,971.99 Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 Depreciation (300,000) (480,000) (288,000) (172,500) (172,500) Taxable income 100,000 (80,000) 112,000 227,500 227,500 Tax @40% (40,000) 32,000 (44,800) (91,000) (91,000) Tax benefit of capital loss 14,800 Net Post Tax Income (including Salvage ) 60,000 (48,000) 67,200 136,500 201,300 Add Back depreciation 300,000 480,000 288,000 172,500 172,500 net Cash Flow (1,500,000) 360,000 432,000 355,200 309,000 373,800 PV factor @7.15% 1 0.933 0.871 0.813 0.759 0.708 PV of Cash flows (1,500,000) 335,974 376,263 288,725 234,409 264,642 NPV = $ 12.43 So at required return rate 7.15% the NPV is close to 0. So IRR =7.15% 3 As per the govt Tax deduction rules NPV /IRR calculation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 MACRS rate 20.00% 32.00% 19.20% 11.50% 11.50% Book value after yr 5= - Salvage value = 50,000 Gain 50,000 Tax on captal loss 20,000 Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 Depreciation (900,000) (150,000) (150,000) (150,000) (150,000) Taxable income (500,000) 250,000 250,000 250,000 250,000 Tax @40% 200,000 (100,000) (100,000) (100,000) (100,000) Tax benefit of capital losson capital gain (20,000) Net Post Tax Income (including Salvage ) (300,000) 150,000 150,000 150,000 180,000 Add Back depreciation 900,000 150,000 150,000 150,000 150,000 net Cash Flow (1,500,000) 600,000 300,000 300,000 300,000 330,000 PV factor @7% 1 0.935 0.873 0.816 0.763 0.713 PV of Cash flows (1,500,000) 560,748 262,032 244,889 228,869 235,285 NPV = $ 31,822.65 Pay Back period= 4 years Accounting rate of return Average yearly accounting return =330000/5= 66,000 Average Investment=(1500000+50000)/2= 775,000 Accounting rate of return= 8.52% IRR Investment (1,500,000) Salvage 50,000 Net Income 400,000 400,000 400,000 400,000 400,000 Depreciation (900,000) (150,000) (150,000) (150,000) (150,000) Taxable income (500,000) 250,000 250,000 250,000 250,000 Tax @40% 200,000 (100,000) (100,000) (100,000) (100,000) Tax benefit of capital losson capital gain (20,000) Net Post Tax Income (including Salvage ) (300,000) 150,000 150,000 150,000 180,000 Add Back depreciation 900,000 150,000 150,000 150,000 150,000 net Cash Flow (1,500,000) 600,000 300,000 300,000 300,000 330,000 PV factor @7.886% 1 0.927 0.859 0.796 0.738 0.684 PV of Cash flows (1,500,000) 556,143 257,745 238,905 221,442 225,782 NPV = $ 17.51 So at required return rate 7.886% the NPV is close to 0. So IRR =7.886% When the require rate of return 12% , the project is not feasible as the IRR is 7.886% only
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