Submitted by: Submitted by kmftdk
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Category: Business and Industry
Date Submitted: 11/15/2011 12:30 PM
Capital Budgeting
Example one - A firm contemplates the construction of a new production facility. Management wishes to determine the effective size of the initial investment (ignoring the tax shields of subsequent capital cost allowances). The building would be built on a piece of vacant land that the firm has owned for 10 years. When first acquired, the land cost $200,000, but its current market value is estimated to be $1,000,000. The building itself can be erected for $350,000. Machinery worth $100,000 needs to be purchased. In addition, essential production equipment manufactured by one of the firm's own divisions would be required. Production costs for this equipment are expected to total $50,000 and to have a ready market price of $60,000. Corporate taxes are 40 percent. Finally, additional investments of $30,000 in working capital (mainly inventories) are required.
Required:
Calculate the amount of the initial investment that would be used in the capital budgeting
Process.
Answer:
Price Tax After Tax
Land $1 000 000 ($160 000) $840 000
Building 350 000
Machinery 100 000
Production Equipment 60 000 (4 000) 56 000
Working Capital 30 000 Net Initial Investment $ 1 376 000
Opportunity Cost of Land = Current Market Value 1 000 000
Less acquisition cost (200 000)
Multiplied by capital gains tax effect 50 %
Multiplied by income tax effect 40% $160 000
Opportunity Cost of = Current Market Value 60 000
Production Equipment Less production cost (50 000)
Multiplied by income tax effect 40%
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