BUS 5110 - Managerial Accounting

Written Assignment Unit 5

CAPITAL BUDGETING CALCULATION

University of The People

May 2021
Case Study:

A manufacturing company is evaluating two options for new equipment to introduce a new product

to its suite of goods. The details for each option are provided below:

OPTION 1 

 $75,000 for equipment with useful life of 7 years and no salvage value. 
 Maintenance costs are expected to be $2,500 per year and increase by 3% in Year 6 and
remain at that rate. 
 Materials in Year 1 are estimated to be $20,000 but remain constant at $10,000 per year
for the remaining years. 
 Labor is estimated to start at $50,000 in Year 1, increasing by 3% each year after. 
 Required rate of return at 8%

Revenues are estimated to be: 

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

-    50,000    113,000    125,000    125,000    150,000    150,000

The calculation :

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Purchase (75,000
Price .00)              
Maintenan (2,500. (2,500 (2,500. (2,500. (2,500. (2,575. (2,575.
ce Cost   00) .00) 00) 00) 00) 00) 00)
(20,000. (10,000 (10,000. (10,000. (10,000. (10,000. (10,000.
Materials   00) .00) 00) 00) 00) 00) 00)
Added (50,000. (51,500 (53,045. (54,636. (56,275. (57,963. (59,702.
Labor   00) .00) 00) 35) 44) 70) 61)
50,000 113,000 125,000 125,000 150,000 150,000
Revenue   - .00 .00 .00 .00 .00 .00
Net Cash (75,000 (72,500. (14,000 47,455 57,863 56,224 79,461 77,722
Flows .00) 00) .00) .00 .65 .56 .30 .39
PV
factor 100% 93% 86% 79% 74% 68% 63% 58%
PV of
cash (75,000 (67,129. (12,002 37,671 42,531 38,265 50,074 45,350
flow .00) 63) .74) .31 .51 .49 .10 .27
Cumulat (75,000 (142,129. (154,132. (116,461. (73,929. (35,664. 14,410 59,760
ive PV .00) 63) 37) 06) 55) 06) .03 .30

1) Net Present Value (NPV) = the difference between the present value of cash inflows

and outflows over a period of time.

Based on the table above, we see: NPV = Cumulative PV in year 7

= $ 59,760.30.

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 According to Fernando (2021), a positive NPV indicates a profitable investment.

Because option 1 has a positive NPV, indicating return or profit will be made.

2) Internal Rate of Return (IRR) = the discount rate that makes NPV of all cash flows

equal to zero.

The calculation is : NPV = NCF0 + NCF1/(1+IRR) +... + NCF1/(1+IRR) n

0 = (75,000.00) + (72,500.00)/(1+IRR) +
(14,000.00)/(1+IRR)2 + ... + 77,722.39/(1+IRR)7

IRR calculations can be done using Microsoft Excel's formula, which determines the

value of IRR option 1 as 16.24%.

According to Dikov (2019), a positive IRR indicates that the project will be profitable,

whereas a negative IRR indicates that it will generate a loss. Because option 1 has a

greater IRR than the company's required rate of return (8%) this indicates the company

should accept option 1.

3) Payback Period is a measure of how long it will take to recover the initial investment.

(Kagan, 2021).

Payback
  Net Cash Flows Balance
Year 0 (75,000.00) (75,000.00)
Year 1 (72,500.00) (147,500.00)
Year 2 (14,000.00) (161,500.00)
Year 3 47,455.00 (114,045.00)
Year 4 57,863.65 (56,181.35)
Year 5 56,224.56 43.21
Year 6 79,461.30 79,504.51
Year 7 77,722.39 157,226.89

Based on the table above, we see: option 1 has a payback period of 6 years without

considering time value of money.

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OPTION 2 

 $50,000 for equipment with useful life of 7 years and a $10,000 salvage value 
 Maintenance costs are expected to be $4,500 per year and increase by 3% in Year 6 and
remain at that rate. 
 Materials in Year 1 are estimated to be $25,000 but remain constant at $20,000 per year
for the remaining years. 
 Labor is estimated to start at $70,000 in Year 1, increasing by 3% each year after.
 Required rate of return at 8%

Revenues are estimated to be:

Year
Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
1
         
-    150,000
75,000 100,000 125,000 155,000 200,000

The calculation :
    Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Purchase (50,000.
Price 00)              
Maintenan (4,500. (4,500. (4,500. (4,500. (4,500. (4,635. (4,635.
ce Cost   00) 00) 00) 00) 00) 00) 00)
(25,000. (20,000. (20,000. (20,000. (20,000. (20,000. (20,000.
Materials   00) 00) 00) 00) 00) 00) 00)
Added (70,000. (72,100. (74,263. (76,490. (78,785. (81,149. (83,583.
Labor   00) 00) 00) 89) 62) 19) 66)
75,000. 100,000. 125,000. 155,000. 200,000. 150,000.
Revenue   - 00 00 00 00 00 00
Net Cash (50,000. (99,500. (21,600. 1,237. 24,009. 51,714. 94,215. 41,781.
Flows 00) 00) 00) 00 11 38 81 34
PV factor 100% 93% 86% 79% 74% 68% 63% 58%
PV of (50,000. (92,129. (18,518. 981. 17,647. 35,195. 59,371. 24,379.
cash flow 00) 63) 52) 97 41 94 94 01
Cumulati (50,000. (142,129. (160,648. (159,666. (142,018. (106,822. (47,450. (23,071.
ve PV 00) 63) 15) 18) 77) 82) 88) 87)

1) NPV

Based on the table above, we see: NPV = Cumulative PV in year 7

= $ (23,071.87)

Option 2 has a negative NPV, indicating no return or profit.

2) IRR

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 With a formula available in Excel, the IRR for option-2 was found to be 4.6%.

Because the IRR is lower than the required rate of return (8%), indicating the

company should not accept option 2.

3) Payback period

Payback
  Net Cash Flows Balance
Year 0 (50,000.00) (50,000.00)
Year 1 (99,500.00) (149,500.00)
Year 2 (21,600.00) (171,100.00)
Year 3 1,237.00 (169,863.00)
Year 4 24,009.11 (145,853.89)
Year 5 51,714.38 (94,139.51)
Year 6 94,215.81 76.31
Year 7 41,781.34 41,857.65

Based on the table above, we see: option 2 has a payback period more than 7 years.

Recomendation:

Capital budgeting calculations provide evidence that option 1 is more profitable than option

2, so it is recommended the company invest in option 1.

References :

Dikov, D. (2019, December 20). Internal Rate Of Return (IRR) In Financial Analysis.
Magnimetrics. https://magnimetrics.com/internal-rate-of-return-irr-in-financial-
analysis/.

Fernando, J. (2021, May 18). Net Present Value (NPV). Investopedia.

https://www.investopedia.com/terms/n/npv.asp#:~:text=Net%20present%20value
%20(NPV)%20is,a%20projected%20investment%20or%20project.

Kagan, J. (2021, May 7). Payback Period Definition. Investopedia.

https://www.investopedia.com/terms/p/paybackperiod.asp.