University of Central Florida                       College of Business Administration                       Department of Finance

 Capital Budgeting: Team Problem

          Gizmo Corporation expects rapidly increasing demand for gizmos, and is considering expansion of its production facility.  The project would require the firm to purchase new equipment and upgrade old software.  The cost of the new equipment is $1,250,000.   Delivery  would cost $50,000 and installation would amount to $30,000.  The equipment would have a class life of 7 years, but the firm is planning to keep the equipment for 5 years.  Gizmo executives expect to be able to sell the equipment for $200,000 at the end of the fifth year.

           A one-time working capital investment of $40,000 would be required at the time of installation.  The firm would also be required to train employees to use the new equipment.  The training program would cost $5,000.

           Gizmo Corporation uses simplified straight line depreciation, has a marginal cost of capital of 11 percent, and has a marginal tax rate of 34 percent.  Since the capital investment represents expansion of the firm's current line of business, the risk of the project is equivalent to the overall risk of the firm.

           Following are current annual sales and expense figures, and forecasts of annual sales and expense numbers if the capital investment project is undertaken.

                                                   Existing              With new equipment

           Sales                                $2,750,000              $3,500,000

          Cash operating expenses        1,200,000               1,400,000

          Cost of defects                       40,000                  15,000

          Maintenance cost                   20,000                   30,000

  

          Should the firm invest in this expansion project?