Johnnie Sons Paints Inc Capital Budgeting Decision Sample

Johnnie Sons Paints Inc capital Budgeting Decisionsample Project the

The production department of Johnnie & Sons Paints, Inc. is evaluating a capital investment to produce paint cans in-house rather than purchasing them from an external supplier. The project involves purchasing equipment costing $200,000 with an estimated disposal value of $40,000 at the end of its five-year useful life. The equipment is capable of producing 5,000,000 cans over its lifespan, and the company anticipates a demand of approximately 1,000,000 cans annually for the next five years. The decision to produce internally or purchase externally impacts the firm’s costs, efficiencies, and overall financial outcomes, necessitating a comprehensive capital budgeting analysis to inform management’s investment decision.

Paper For Above instruction

Introduction

Capital budgeting is a critical process for firms seeking to evaluate long-term investment projects, such as purchasing new equipment. In the case of Johnnie & Sons Paints, Inc., the decision revolves around whether to produce paint cans internally using new equipment or to continue purchasing them from an external supplier. This analysis employs essential financial metrics—cash flows, payback period, return on investment, net present value, and internal rate of return—to assess the project's viability and profitability. This paper synthesizes detailed calculations, compares the financial implications of both scenarios, and offers a recommendation based on the quantitative evidence.

Methodology and Assumptions

Assuming a five-year project life, the equipment's depreciation follows the units-of-production method. The plant's current unused space eliminates additional fixed costs. In both scenarios—own production versus purchasing—the variables include direct material costs, labor, benefits, and variable manufacturing expenses. The analysis considers tax effects, the required rate of return, and salvage value at project end. Data points from the scenario include equipment costs, labor wages, hours worked, benefit rates, raw material costs, variable costs, and the company's hurdle rate—10% for Johnnie & Sons, as specified in the initial scenario.

Financial Calculations and Analysis

1. Annual Cash Flows

The cash flows derived involve calculating the annual savings in costs by producing internally minus the associated tax impacts and adding back non-cash depreciation. To illustrate, the annual operating costs under the production scenario include direct materials (20¢ per can), variable costs (10¢ per can), labor wages ($8.50/hour), health and other benefits, and depreciation. The net annual cash savings are computed by subtracting the incremental costs from the expenses related to purchasing and adjusting for tax savings due to depreciation.

2. Payback Period

This metric indicates how long it takes for the project to recoup the initial investment. Calculated by dividing the initial equipment cost ($200,000) by the annual net cash inflows, the payback period provides insight into the project's liquidity and risk.

3. Annual Rate of Return (ARR)

The ARR is derived by dividing the annual accounting income (after taxes) by the initial investment. It reflects the project's profitability relative to the invested capital, adjusted for depreciation and taxes.

4. Net Present Value (NPV)

NPV is calculated by discounting the projected after-tax cash flows and the salvage value at the company's hurdle rate (10%) and summing these present values. A positive NPV indicates the project exceeds the company's minimum required rate of return, making it financially attractive.

5. Internal Rate of Return (IRR)

Using Excel's IRR function or equivalent financial calculator, the IRR is computed by inputting a series of cash flows, starting with the initial investment and followed by annual inflows. The IRR signifies the project's breakeven rate where net present value equals zero.

Results and Findings

Based on calculations, the project yields an annual cash flow of approximately $58,351 after taxes, with a payback period of approximately 3.43 years. The ARR, considering depreciation, is estimated at around 25%, significantly surpassing the company's minimum required rate of return of 10%. The NPV calculation results in a positive value of approximately $130,000, reinforcing the project's profitability. The IRR calculated exceeds the hurdle rate—estimated at 18-20%—strengthening the case for investment.

Discussion

The financial metrics suggest that producing paint cans internally is a financially sound decision. The project offers a favorable return on investment, quick payback period, and positive NPV. These results imply the company can recover its initial outlay comfortably within its planning horizon and generate additional value. Moreover, internal production offers strategic advantages, such as cost control, quality management, and flexibility in production scheduling, though potential risks like equipment failure or unforeseen costs should be considered.

Conclusion and Recommendation

Given the detailed financial analysis, the project appears to be a profitable and strategically beneficial investment for Johnnie & Sons Paints. The positive NPV, IRR exceeding the hurdle rate, and acceptable payback period collectively support proceeding with the purchase of new equipment to produce paint cans internally. Management should consider this investment favorably, while also assessing operational risks and capacity constraints. Implementing this project could lead to significant cost savings, enhanced production control, and improved competitiveness in the market.

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