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Making Capital Investment Decisions

Learn how to apply techniques for capital investment decisions using NPV and IRR calculations. Explore examples on cost cutting, bid price setting, and equivalent annual cost analysis.

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Making Capital Investment Decisions

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  1. Lecture 10 (Ch 10) Making Capital Investment Decisions

  2. Making The Decision • Now that we have the cash flows, we can apply the techniques that we learned in chapter 9 • Enter the cash flows into the calculator and compute NPV and IRR • CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780 • NPV; I = 20; CPT NPV = 10,648 • CPT IRR = 25.8% • Should we accept or reject the project?

  3. Example: Cost Cutting • Your company is considering new computer system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%. • Click on the Excel icon to work through the example

  4. Example: Setting the Bid Price • Consider the example in the book: • Need to produce 5 modified trucks per year for 4 years • We can buy the truck platforms for $10,000 each • Facilities will be leased for $24,000 per year • Labor and material costs are $4,000 per truck • Need $60,000 investment in new equipment, depreciated straight-line to a zero salvage • Actually expect to sell it for $5000 at the end of 4 years • Need $40,000 in net working capital • Tax rate is 39% • Required return is 20%

  5. Machine A Initial Cost = $5,000,000 Pre-tax operating cost = $500,000 Straight-line depreciation over 5 year life Expected salvage = $400,000 Machine B Initial Cost = $6,000,000 Pre-tax operating cost = $450,000 Straight-line depreciation over 8 year life Expected salvage = $700,000 Example: Equivalent Annual Cost Analysis The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required. The required return is 9% and the tax rate is 40%.

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