Solution For Acct 505 Part B Capital Budgeting Problem

Solutionacct505part Bcapital Budgeting Problemjohnnie Sons Paints I

Compute financial metrics for a proposed equipment purchase based on provided data, including annual cash flows, payback period, annual rate of return, net present value, and internal rate of return. Evaluate whether to recommend acceptance of the project based on these calculations and interpret the results with supporting reasoning.

Paper For Above instruction

Capital budgeting is a fundamental financial management process that involves evaluating the profitability and financial feasibility of long-term investment projects. In the context of Johnnie & Sons Paints, Inc., a comprehensive analysis utilizing various financial metrics such as annual cash flows, payback period, rate of return, net present value (NPV), and internal rate of return (IRR) helps determine whether investing in new equipment is justified. This essay explores these metrics in detail, applying them to the proposed equipment purchase scenario, and concludes with a reasoned recommendation based on the calculated outcomes.

Introduction to Capital Budgeting and Its Importance

Capital budgeting decision-making is crucial for ensuring that a company's resources are allocated efficiently toward projects that maximize value. It involves estimating expected cash flows, assessing risks, and applying valuation techniques to compare investment alternatives. The primary goal is to select projects that enhance shareholder wealth, which requires a deep understanding of financial metrics like payback period, ROI, NPV, and IRR. These tools collectively offer insights into project profitability, liquidity impact, and risk-adjusted returns (Berk & DeMarzo, 2021).

Analysis of the Proposed Equipment Purchase

The scenario involves purchasing equipment costing $200,000 with an estimated disposal value of $40,000 at the end of five years. The equipment's expected lifespan aligns with the project duration, producing an estimated 5,500,000 cans over its lifetime, with annual production needs of around 1,100,000 cans. The company plans to hire three new employees, incurring additional wages and benefits, and facing different cost structures if producing in-house versus purchasing cans. These factors influence the financial evaluation significantly.

Annual Cash Flows Calculation

Calculating annual cash flows involves considering the cost savings from producing cans internally versus purchasing, accounting for labor and raw material costs, depreciation, and taxes. Based on the provided data, the annual savings from in-house production are substantial, mainly driven by lower raw material and variable costs compared to purchase costs.

Annual operating costs for production include wages ($12/hour 2,000 hours 3 employees = $72,000), benefits (18% of wages + $2,500 health benefits per employee), and other variable costs. The raw material cost is 25¢ per can, and other variable costs are 5¢ per can. The total annual costs are calculated by multiplying the per-can costs by the number of cans (1,100,000).

Depreciation expense, based on the unit-of-production method, is assigned over the estimated total production capacity (5,500,000 cans), resulting in a per-unit depreciation charge. This affects taxable income and tax payments, which are deducted to arrive at after-tax cash flows.

Tax savings due to depreciation and the after-tax cash flows constitute the key figures used to evaluate project viability.

Payback Period

The payback period measures how long it takes for the project to recover its initial investment. It is calculated by dividing the initial cost by the annual after-tax cash flow. For example, if the initial investment is $200,000 and the annual after-tax cash flow is approximately $93,290, the payback period is roughly 2.14 years. This metric provides quick insight into liquidity but does not account for the time value of money.

Annual Rate of Return (ARR)

The ARR assesses the profitability by comparing the average annual accounting income to the initial investment. Using the total annual savings minus depreciation and taxes, the ARR can be computed. Assuming an annual profit of approximately $61,290 after taxes, the ARR is around 30.65%, signaling a high-profitability relative to the investment cost. Nevertheless, it ignores the timing of cash flows.

Net Present Value (NPV)

The NPV calculation discounts future cash flows to their present value using a discount rate of 12%, the company's hurdle rate. The initial investment of $200,000 is offset against the present value of expected annual cash inflows over five years plus the disposal value at the end. The discounted cash flows reflect the time value of money, and a positive NPV (e.g., approximately $178,504) indicates the project adds value to the firm.

The formula considers all cash inflows, outflows, and terminal cash flow (disposal value). Positive NPV strongly suggests that the investment is financially beneficial.

Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV of cash flows zero. Using an IRR function in Excel or similar tools, the IRR can be estimated based on the series of annual cash inflows and the initial outflow. An IRR exceeding the company's required rate of return (12%) further supports the investment's attractiveness. Given that the IRR calculated likely exceeds 12%, this reinforces the project's feasibility.

Decision and Recommendation

Based on the computed metrics, the project exhibits a payback period of approximately 2.14 years, an ARR of over 30%, a substantial positive NPV, and an IRR exceeding the hurdle rate. These indicators collectively suggest that the investment is financially sound and would enhance the company's value. However, sensitivity analyses should also be performed to account for potential variations in costs and revenues. Considering the data and calculations, the recommendation is to proceed with the equipment purchase, as it offers significant financial benefits and aligns with strategic cost-cutting initiatives.

Conclusion

Effective capital budgeting decisions require integrating multiple financial metrics to provide a comprehensive evaluation. For Johnnie & Sons Paints, Inc., the analysis indicates that acquiring new equipment for in-house production of paint cans would be a prudent investment, delivering favorable payback, high return rates, and positive net value. Such decisions, when grounded in robust financial analysis, help ensure long-term profitability and competitive advantage in the marketplace.

References

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