CAPITAL BUDGETING

CASE 1: Sinclair Company

A. EQUIPMENT REPLACEMENT

Question #1

Assuming the present equipment has zero book value and zero salvage value, should the
company buy the proposed equipment?

Investment.............................................................................................................................................................
$250,000
Annual savings......................................................................................................................................................
72,000
Present value of $1 a year, 5 years, 15 percent .....................................................................................................
3.352
Total present value of savings ..............................................................................................................................
241,344

Decision: Do not purchase, since net present value is -$8,656.

Question #2

Assuming the present equipment is being depreciated at a straight-line rate of 10%, that it
has a book value of $135,000 *cost, $225,000; accumulated depreciation, $90,000), and has zero
net salvage value today, should the company buy the proposed equipment?

Investment.............................................................................................................................................................
$250,000
Annual savings......................................................................................................................................................
72,000
Present value of $1 a year, 5 years, 15 percent .....................................................................................................
3.352
Total present value of savings ..............................................................................................................................
241,344

Decision: Do not purchase, since net present value is -$8,656.

Question #3

Assuming that the present equipment has a book value of $135,000 and a salvage value
today of $75,000 and that if retained for 5 more years its salvage value will be zero (0), should
the company buy the proposed equipment?

Investment, gross ..................................................................................................................................................

$250,000
Less salvage on old ...........................................................................................................................................
75,000
Net investment................................................................................................................................................
175,000
Annual earnings ....................................................................................................................................................
72,000
Present value: $72,000 * 3.352 .............................................................................................................................
241,344

Decision: Purchase, since net present value is $66,344.

Question #4

Assume the new equipment will save only $37,500 a year, but that its economic life is
expected to be 10 years. If other conditions are as described in (1) above, should the company
buy the proposed equipment?

Investment.............................................................................................................................................................
$250,000
Annual earnings ....................................................................................................................................................
37,500
Present value, 10 years, 15%: $37,500 * 5.019 ....................................................................................................
188,213

Decision: Do not purchase, since net present value is -$61,787.

B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT

Question #1

Investment ............................................................................................................................................................................
$500,000
Annual earnings....................................................................................................................................................................
160,000
Present value: $160,000 * 3.352 ..........................................................................................................................................
536,320

Decision: Purchase, since net present value is $36,320.

(If Model A has resale value, the return would be even higher.)

C. CHANGES IN EARNING PATTERNS

Question #1

What action should the company take?

Investment .........................................................................................................................................................................
$250,000
Present value of earnings
Years 1-3: $79,500 * 2.283..........................................................................................................................................
$181,499
Years 4-5: $60,750 * 1.069*........................................................................................................................................
64,942
Total PV of earnings ...............................................................................................................................................
$246,441

Decision: Do not purchase, since NPV = - $3,559.

*This is the difference between 3.352 and 2.283

Question #2

Why is the result here different from that in PART A (1)?

Although the total earnings for the 5-year period are the same in Part C as in A (1),
shifting more of the earnings to the early years and less to the later years increases the present
value from $241,344 to $246,441.