Principles of Finance |Capital Budgeting Case
Introduction
In November, 2017, Container Corporation was examining two investment proposals for the forthcoming year. One proposal was to replace a packaging machine that was causing considerable problems on the assembly line. The other proposal was to install a series of machines that would greatly improve the process of plastic-film-bubble packaging. This is an area that is expanding rapidly and one in which the firm has not yet participated to any extent.
Company Background
The company started in the late 1940s by purchasing surplus government cartons and reselling them to the business community in the San Francisco area, and within a few years, it became a major distributor and supplier of corrugated cartons, paper boxes, paper, and miscellaneous supply items. As it grew, equipment for cutting, wrapping, and processing paper and boxes was purchased and the company became a manufacturer of corrugated cartons, which formerly were purchase and then redistributed.
In 1960, plastics began to substitute for paper bags and cartons. The company entered this new area by selling plastic film and bags as well as the machines for packaging items into plastic bags and film. It further expanded by putting a plastic coating onto the paper boards and then die-cutting them to various sizes and shapes. Added to these activities was the selling of printing equipment, cameras and plates for the printing, and additional die-cutting and coating items. Showrooms were added to exhibit the various types of machinery available to manufacturers who wished to display their products in clear packages.
Thus, the company today is a supplier both of machinery and supplies to those manufacturers who want to package their own merchandise and of packages for manufacturers who prefer to outsource this part of their production process.
Investment Alternatives
The first investment alternative to consider is the replacement of the packaging machine. The machine currently being used was purchased 5 years earlier for $30,000. At that time, the firm decided to depreciate the machine on a straight-line basis over 15 years, thus generating $2,000 in depreciation expense each year. At the end of its 15-year life, there is no anticipated salvage value. In other words. At that time, the machine is expected to be worthless. At the present time, the old machine is contributing $17,500 annually to revenues while the operating expenses have been running $10,000 per year. It can be sold today for $7,500.
If the new machine were purchased now, it would cost the company $35,000. The new machine would have a useful life of 10 years. The depreciation method would be MACRS 7-year. It is estimated that the new machine would contribute $25,000 to revenues each year, with annual operating costs of $8,000. For the investment analysis, a 40% tax rate would be appropriate.
The second investment alternative is a series of machines that would greatly enhance the firm’s ability to enter the bubble packaging business. The total cost of this investment package would be $1 million. The equipment would have a useful life of 10 years and would be depreciated using MACRS 7-year. It is anticipated that the new machines will generate annual sales (revenue) increases as shown in Exhibit 1 below. The machines would require a net working capital investment of $62,500. At the end of their useful life, the machines are expected to be worthless and will generate no salvage value. As with the other investment opportunity, the appropriate tax rate is 40%
The following is the current balance sheet for Container Corporation. All amounts are in millions of dollars. The current capital structure is to be maintained.
Cash$10Accounts payable$10
Accounts receivable20Accruals10
Inventories20Short-term debt5
Current assets50 Current liabilities25
Gross fixed assets120Long-term debt (bonds)40
Accum depreciation50Preferred stock0
Net fixed assets70Common stock2
Paid-in capital28
Retained earnings50
Total assets120Total liab & equity120
The following information has been gathered regarding Container Corporation’s capital.
1.The firm has outstanding an issue of 8%, semiannual coupon, noncallable bonds with 18 years to maturity. New bonds with these characteristic could be sold for a price of $1,185. The bonds will have a par value of $1,000. Flotation costs on new bonds are expected to be 5%.
2.Container Corporation has no preferred stock. There are no plans to issue preferred stock in the foreseeable future.
3.The firm’s common stock is currently selling at $125 per share. The last dividend paid was D0 = $3.25. Dividends are paid semiannually and investors expect the dividend to grow at a constant 5% annual rate into the foreseeable future. Any new common stock issued would involve flotation costs of $3.00 per share.
The president of Container Corporation has assigned you to provide her with the following:
1. a worksheet showing calculation of the company’s weighted average cost of capital (WACC);
2. a worksheet showing initial, operating, and terminal cash flows for the replacement project analysis;
3. a worksheet showing the net present value and internal rate of return for the replacement project analysis;
4. a worksheet showing initial, operating, and terminal cash flows for the new project analysis; and
5. a worksheet showing the net present value and internal rate of return for the new project analysis.
In addition to the above, the president wants your recommendation about whether Container Corporation should invest in one or both of the projects. She also wants a thorough explanation of your recommendations. All worksheets and recommendations/explanations must be typed.
Exhibit 1.
Year Forecast Sales
1 $ 250,000
2 500,000
3 750,000
4 1,000,000
5 1,000,000
6 1,000,000
7 750,000
8 500,000
9 350,000
10 250,000
MACRS
ownership Class of Investment
year 3-year 5-year 7-year 10-year
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 17 14
4 7 12 13 12
5 11 9 9
6 6 9 7
7 9 7
8 4 7
9 7
10 6
11 3
