Problem: Capital Budgeting
X Company is considering replacing an existing processor with a new processor that costs $200,000. Shipping and setup costs for the new processor are estimated to be $15,000. X's working capital requirement is expected to increase by $17,000 when the new processor begins operation and is expected to be fully recoverable at the end of the project. The new processor's useful life is expected to be 5 years and its salvage value at that point is estimated to be $60,000. The old processor had an installed cost of $150,000 when it was placed in service three years ago and is also being depreciated using a 5-year ACRS life. The old processor can be sold today for $50,000. Estimated incremental revenues and incremental cash operating expenses for the new processor before tax for each year are shown in the table below. Note that you will have to calculate the incremental depreciation for the two years of overlap of the expected lives of the old and new processors.
| Year |
Incremental Revenues |
Incremental Cash Operating Expenses |
ACRS Depr. % |
| 1 |
$87,000 |
$23,000
|
15 |
| 2 |
$82,000 |
$25,000 |
22 |
| 3 |
$93,000 |
$30,000 |
21 |
| 4 |
$87,000 |
$23,000 |
21 |
| 5 |
$88,000 |
$29,000 |
21 |
Note that there is an after tax salvage value both at the beginning and the end of this project. Assume a tax rate of 35% and a cost of capital of 12%.
Show the calculations for the initial investment and the OCFAT for each year. Then use your financial calculator to find the NPV and IRR for the project. In addition to the OCFAT's shown, indicate the value that you enter for the initial investment, CF0, and the cost of capital, I. Based on the NPV and IRR, should company X invest in the new processor?