Capital Budgeting Decision
Instructions: Prepare your solution to this problem in your choice of formatting, but in Excel. You may use a timeline format or a table, as illustrated in the text. Be thorough in your response, showing calculations and explaining your entries. Use appropriate rationale to make a recommendation. Your client has hired you to give advice, and needs an explanation as to your conclusions.
Background information: The Hilltop Corporation is considering purchasing a replacement for an older machine that is being used in production. The old machine is fully depreciated, and would be sold for $50,000 at the same time the new machine is purchased. Hilltop uses the straight-line method of depreciation (without regard to salvage value) for all of its machinery.
A new and more efficient machine could be purchased to replace the older machine at a price of $500,000. Initial training for employees on the new machine would cost $7,000. The new machine would produce annual cash savings of $150,000 for 6 years. At the end of 6 years, the machine could be sold for $100,000. For depreciation purposes, the machine has a useful life of 10 years. At the end of the third year of production, the new machine would require scheduled maintenance and upgrades which costs $40,000.
Additional inventory ($45,000) and cash ($20,000) would be required, if the new machine is purchased. Corresponding accounts payable would also be anticipated ($25,000). The tax rate for Hilltop Corporation is 35%. The required rate of return, annually, for the firm is 16%.
Required:
1. Calculate the Net Present Value of the new machine, showing detail of how the NPV was found.
2. Calculate and report the Internal Rate of Return on the new machine. Explain the importance of this rate for making investment decisions with limited resources and considering that there may be competing investment opportunities.
3. What is the undiscounted payback period for this proposed project? Show your work.
4. Make clear a recommendation to your client, explaining your reasoning. Demonstrate an understanding of Net Present Value, Discount Rates and Internal Rate of Return.