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Capital Budgeting Analysis for ABC Corporation and Intuitive Technology

## ABC Corporation Location Analysis

ABC Corporation wants to relocate its new warehouse in order to save money. The expected savings (cash flow) in the next five years in each location are shown in the following tables. The investment required and cash flows depend on the location, access to highways, local taxes and other related costs associated with the location.

Calculate the Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR) and profitability index of each location.  Based on the four capital budgeting tools, create a table, and based on your findings, recommend where ABC build its new warehouse.  The locations are mutually exclusive, which means ABC can choose only one location.

Please note that each location has a different cost of capital to allow for the different risks associated with each location. All the numbers are in thousands of dollars.

Cranbrook, BC

 Year: 0 1 2 3 4 5 Cash flow: - \$5,000 \$2,000 \$2,000 \$2,000 \$2,000 \$2,000

Cost of Capital: 6%

Okotoks, AB

 Year: 0 1 2 3 4 5 Cash flow: - \$6,000 \$2,500 \$2,500 \$2,500 \$2,500 \$2,500

Cost of Capital: 7%

Kindersley, SK

 Year: 0 1 2 3 4 5 Cash flow: - \$7,000 \$3,000 \$3,000 \$3,000 \$3,000 \$3,000

Cost of Capital: 8%

Onoway, AB

 Year: 0 1 2 3 4 5 Cash flow: - \$8,000 \$3,200 \$3,200 \$3,200 \$3,200 \$3,200

Cost of Capital: 9%

Morden, MB

 Year: 0 1 2 3 4 5 Cash flow: - \$7,500 \$3,100 \$3,100 \$3,100 \$3,000 \$3,100

Cost of Capital: 8%.

Stephen Herron, owner of a small manufacturer, Intuitive Technology (IT), has asked you to provide your opinion on the options available to replace an old machine. Two suppliers have provided price and cost estimates. The supplier of the old machine, Canadian Equipment Inc. (CEI), has improved its equipment but continues with the same specialized design. A new supplier, Alto Design Equipment (ADE), has a new innovative design that can process the products produced by IT.

Stephen is excited about the new design. Its products usually have a short life cycle where sales increase for five years and then decline. IT could use the new design proposed by ADE to process its products that will stabilize output over the next five years. IT’s cost of capital is 10%. After careful analysis of the two designs, he prepares the following forecast of the expected cash flows.

After-tax cash inflows and outflows for CEI and ADE equipment (\$000)

 Machine Initial investment Incremental after-tax cash flowin period 1 2 3 4 5 CEI – \$150,000 \$ 60,000 \$ 50,000 \$ 50,000 \$ 35,000 \$ 35,000 ADE – \$260,000 50,000 40,000 30,000 25,000 25,000

1. Stephen believes in the Payback Period technique. He believes that any project that does not return its cost within three years should not be undertaken. Which machine should IT buy if the Payback Period technique is used?

2. Stephen’s wife, a business school graduate, likes the NPV method, since she knows that this method explicitly considers the cost of financing associated with the investment, as well as the time at which cash flows occur. Calculate the NPV and Profitability Index (PI) of each project. Which machine should IT buy according to this criterion?

3. Stephen’s neighbor is a business analyst and he considers Internal Rate of Return to be far superior method to analyze projects.  He determines that, for this type of equipment, the rate of return should be at least 17%.  Calculate the IRR for CEI and ADE.

Write a memo to Stephen to help him decide which method he should use in making his decision. In your memo, include a table that shows your results for each of the methods, as shown below. Include a short description of your analysis, the results of each method, and your final reasoned recommendation.

 Machine Initial investment Payback Period NPV IRR P.I. CEI – \$150,000 ADE – \$260,000