Capital Budgeting

Question 1:

The RW Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $9 million (the existing equipment has zero salvage value). The attraction of the new machinery is that it is expected to cut manufacturing costs from their current level of $8 a welt to $4. However, as the following table shows, there is some uncertainty both about future sales and about the performance of the new machinery:

  Pessimistic Expected Optimistic
Sales, millions of welts 0.4 0.5 0.7
Manufacturing cost with new machinery, dollars per welt 6 4 3
Economic life of new machinery, years 7 10 13

Calculate the annual cost savings of the expected scenario. Assume a discount rate of 12%. RW does not pay taxes.

Question 2:

The manufacture of polysyllabic acid is a competitive industry. This acid is used in urinary lab tests by most hospitals and clinics. Most plants have an annual output of 100,000 tons. Operating costs are $.90 a ton, and the sales price is $1 a ton. A 100,000-ton plant costs $100,000 and has an indefinite life. Its current scrap value of $60,000 is expected to decline to $57,900 over the next two years. Polysyllabic, Inc., proposes to invest $100,000 in a plant that employs a new low-cost process to manufacture polysyllabic acid. The plant has the same capacity as existing units, but operating costs are $.85 a ton. Polysyllabic estimates that it has two years’ lead over each of its rivals in use of the process but is unable to build any more plants itself before year 2. Also, it believes that demand over the next two years is likely to be sluggish and that its new plant will therefore cause temporary overcapacity. By the end of year 2, the prospective increase in acid demand will require the construction of several new plants. What is the likely NPV of such plants? What does that imply for the price of polysyllabic acid in year 3 and beyond? Would you expect the existing plant to be scrapped in year 2? How would your answer differ if scrap value were $40,000 or $80,000?

***This assignment is to work two problems. The second question will require a bit of a discussion (a paragraph or two maximum) and it not purely a quantitative question in contrast to the first one , which is purely quantitative.***

The paper should be three pages in length (excluding cover page and references) Be sure to discuss and reference concepts taken from the assigned textbook reading and relevant research.

 

Textbook- Principles of Corporate Finance chapters 3, 6 and 7 by Brealey, R., Myers, S., & Allen, F. (2013). Principles of Corporate Finance (11th ed.) New York: McGraw-Hill Education Group. ISBN-13: 9780078034763.

 

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