This case, in addition to reviewing the methods of ranking investment opportunities, go

estimation of the cash flows of the project. We must estimate the cash flows and not the inc
with cash that we can pay our employees, our suppliers, and our shareholders. You pay none
you require the cash to do so.

ITEMS TO CONSIDER
CASH FLOWS must be
Incremental. Only the cash flows that the company earns in addition to what it would h
project. Many times an additional product line may cannibalize sales of an existing product

AFTER TAX All cash flows must be on a after tax basis. The owners of the firm are not c
the only money that accrues to them is on an after tax basis.

INITIIAL OUTLAY Many time large projects may take 1,2, 3, or more years to complete, h
costs occur in year 0. These cost can include purchase of property, plant, and equipment. T
set-up of equipment, and increases in working capital.

TERMINAL CASH FLOWS These are the cashflows that company expects to get when th
after tax benefits of the sale of the land, buildings, and equipment.

ITEMS NOT CONSIDERED

FINANCING COSTS You will notice we make no mention of financing cost when comple
While financing cost are important they are actually accounted for in the WACC that we use
estment opportunities, goes into greater detail on the
cash flows and not the income because it is only
hareholders. You pay none of the above with income

ddition to what it would have earned without the

wners of the firm are not concerned with before tax cash flows

more years to complete, however for our analysis we assume all of the startup
y, plant, and equipment. They can also included employee training,

ny expects to get when the project ends. These cashflows can include the

ecovered. Example you are considering the purchase of three different

ancing cost when completing the cash flow analysis of the project.
in the WACC that we use to discount all of the future cash flows
Within the realm of capital budgeting the majority of projects are not new product lines or major corporate acquisitions. The vast
majority capital budgeting decisions are replacement projects or projects considered for efficiency gains. These projects are taken on for
efficiency gains. These projects are much less risky than new product or even an expansion of production since you do not have to sell one more project to
increase our net income. A gain in efficiency or in other words a decreasing of expenses immeadetly increases net income and cash flow. It does
not require one addtional item sold. Our case will review an efficiency gain capital budgeting project.
Hence the only cash flows that are impotant are the differential cash flows.

Meadville Widgets is considering the purchase of a fully automated widget finishing machine to replace an older but still functioning but more labor
intensive model. The machine being replaced was purchased 5 years ago for a price of $45,000.00 at which time it had an expected life of 10 years.
This machine is being depreciated by the straight line method with an anticiapated salvage value of $0.00 The current market value of this machine
is estimated to be $27,000.00. The current machine requires one operator with an annual cost of $37,500.00 in salary and benifits.
The replacement machine has a purchase price of $79,500, a 5 year life, and an expected salvage value of $17,000. The new machine will require
a 440 volt three phase electric service and a new concrete pad these installation expenses are $7,500. Meadville Widgets expect the maintence costs to be
$5,000 as compared to the current costs of $6,000 and the defects to be $2,000 compared to current defect costs of $4,000.
Before considering the purchase of the new machine Meadville Widgets conducted and engineering study to determine if the installation costs
would be prohibitive, this study costs $5,000. In order to undertake this project the firm will add $30,000 in debt at 11.5% and the required rate of return is 15%.
Meadville Widgets marginal tax rate is 34%
 The Meadville Widgets Company
Replacement Analysis
Old Machine New Machine Difference
Price 45,000 79,500
Shipping and Install 0 7,500
Original Life 10 5
Current Life 5 5
Original Salvage Value 0 17,000
Current Salvage Value 27,000 -
Book Value 22,500 87,000
Increase in Raw Materials 0 3,000
Depreciation 4,500 14,000 -9,500
Salaries 37,500 - 37,500
Maintenance 6,000 5,000 1,000
Defects 4,000 2,000 2,000
Marginal Tax Rate 34.00% 34.00%
Required Return 15.00% 15.00%
Cash Flows Period Cash Flows
Initial Outlay -64,530 0 -64,530 Initial outlay is after the sale of the old machine
Annual After-Tax Savings 26,730 1 29,960 After tax cash flows are adjusted for taxes
Depreciation Tax Benefit 3,230 2 29,960 The tax benefit of depreciation
Total ATCF 29,960 3 29,960
Terminal Cash Flow 20,000 4 29,960 After tax cash flow of sale of new machine
5 49,960
Payback Period 2.15
Net Present Value (NPV) 45,844.10 Must calculate these values
Profitability Index (PI) 1.71
Internal Rate of Return (IRR) 40.14%
MIRR 28.03%