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GIVEN INFORMATION:

1. The equipment has a delivered cost of $105,000. An additional $5,000 is required to install and test the new system. The installation charge is added to the cost of equipment for purposes of computing depreciation.

2. The new pumping system is classified by the IRS as 5-year property, although it has an 8-year estimated service life. For assets classified by the IRS as 5-year property, the Modified Accelerated Cost Recovery System (MACRS) permits the company to depreciate 5 the asset over 6 years at the following rates: Year 1 = 20 percent, Year 2 = 32 percent, Year 3 = 19 percent, Year 4 = 12 percent, Year 5 = 11 percent, Year 6 = 6 percent. At the end of 8 years, the salvage value is expected to be around 5 percent of the original purchase price, so the best estimate of salvage value at the end of the equipment's service life is $5,000, with removal costs of $1,200.

3. The existing pumping system was purchased at $40,000 eight years ago and has been depreciated on a straight-line basis with an annual depreciation charge of $4,000 over its economic life of 10 years. If the existing system is removed from the well and crated for pickup, it can be sold for $3,500 before tax. It will cost $1,000 to remove the system and crate it.

4. At the time of replacement, the firm will need to increase its net working capital requirements by $4,500 to support inventories.

5. The new pumping system offers lower maintenance costs and frees personnel who would otherwise have to monitor the system. In addition, it reduces product wastage because of a higher cooling efficiency. In total, it is estimated that the yearly savings will amount to $25,000 if the new pumping system is used.

6. The firms weighted average cost of capital is 11%, and the replacement project is perceived to be of average risk.

7. The firms federal-plus-state tax rate is 30 percent.

QUESTIONS:

1. Develop a capital budgeting schedule using the attached Excel spreadsheet that should list all the relevant cash flow items and amounts related to the replacement project over the 8-year expected life of the new pumping system. (Reference Reading: Cash Flow Analysis Example (Replacement Project) of RIC, one of Readings on course syllabus.)

2. Based on the capital budgeting schedule, evaluate the replacement project by computing IRR, MIRR, NPV, and Payback Period. Would you recommend to accept or reject the project?

3. Before you make the final accept/reject decision, what other factors or approaches would you consider further? (Reference Reading: (1) Textbook Chapter 11; (2) Capital Asset Management Process: the Case of Hose & Fittings Corporation by Bae et al., International Journal of Managerial Finance (IJMF), Vol. 1, No. 3, 2005, pp. 204-220, one of Readings on course syllabus.)

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