Capital Budgeting Problem

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BMW Bike is considering building a new plant. Juan Optimist, the company’s marketing manager, is an enthusiastic supporter of the new plant. Mila Pessimist, the company’s chief financial officer, is not so sure that the plant is a good idea. Currently the company purchases its skateboards from foreign manufacturers. The following figures were estimated regarding the construction of a new plant.

Cost of plant4,000,000
Annual cash inflows4,000,000
Annual cash outflows3,600,000
Estimated useful life15 years
Salvage value2,000,000
Discount rate11%

Juan Optimist believes that these figures understate the true potential value of the plant. He suggests that by manufacturing its own bikes the company will benefit from a “buy Filipino” patriotism that he believes is common among bikers. He also notes that the firms have had numerous quality problems with the bikes manufactured by its suppliers. He suggests that the inconsistent quality has resulted in lost sales, increased warranty claims, and some costly lawsuits. Overall, he believes sales will be P200,000 higher each year that projected above and that the savings from lower warranty costs and legal costs will be P100,000 per year. He also believes that the project is not as risky as assumed above, and that an 8% discount rate is more reasonable.

Answer each of the following questions:

a)Compute the net present value of the project based on the original projections. b)Compute the net present value incorporating Juan’s estimates of the value of the intangible benefits, but still using the 11% discount rate. c)Compute the net present value using the original estimates, but employing the 8% discount rate that Juan suggests is more appropriate. d)Comment on your findings.

Solution to Capital Budgeting Problem:

a)The net present value of the project based on the original projections.

Annual Cash Inflows P4,000.000.00
Less: Annual...
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