Reference no: EM132621806

Mini Case #1: Capital Budgeting at Rio Negro, Inc.

Assignment Overview

Rio Negro, Inc. (RNI) is in the business of transporting cargo between ports in California and Washington. Its fleet includes a small dry-cargo vessel, the Maracas. The Maracas is 25 years old and badly in need of an overhaul. It is March 2016, and Michael John, the finance director, has just been presented with a proposal that would require the one-time expenditures shown below in Table 1. If the proposal is accepted, these expenditures will be made in the next few days. Mr. John believes that all these outlays could be depreciated for tax purposes in the seven-year MACRS class (see Table 2 below for rates). Overhaul of the Maracas will begin as soon as the expenditures in Table1 are made, but the vessel will be out of service for several months. The overhauled vessel would resume commercial service in one year. RNI's chief engineer's estimates of the post-overhaul operating costs are in Table 3. In addition to the overhaul described above, the chief engineer suggests installation of a brand- new engine and control system. Installation of this new engine would cost an extra $600,000 (This additional outlay would also qualify for tax depreciation in the seven-year MACRS class.). However, if the additional equipment is installed, it would result in reduced fuel, labor, and maintenance costs as shown in Table 4. The operating cost estimates in Tables 3 and 4 are current for March 2016. However, these costs will increase with inflation, which is forecasted at 1.25% a year. Depreciation and operating costs attributable to the overhaul of the Maracas will begin one year after the vessel is put back into commercial service. The revenues from operating the vessel will be the same for both types of overhaul. Even with the proposed overhaul, the Maracas cannot continue forever. After the overhaul, its remaining useful life is estimated to be only 12 years. Its salvage value when finally taken out of service will be trivial. Thus, Mr. John feels it is unwise to proceed without also considering the purchase of a new vessel. Racette & Sons (R&S), a Colorado shipyard, has approached RNI with a design incorporating a Kort nozzle, extensively automated navigation and power control systems, and much more comfortable accommodations for the crew. R&S is offering the new vessel for a fixed price of $3,000,000, payable half immediately and half on delivery in one year. Estimated annual operating costs of the new vessel are in Table 5. The operating cost estimates in the table are current for March 2016, but will increase with inflation. The crew would require additional training to handle the new vessel's more complex and sophisticated equipment. Training would result in a one-time cost of $50,000 payable one year following delivery of the new vessel. This cost is tax deductible. The estimated operating costs for the new vessel assume that it would be operated in the same way as the Maracas. However, the new vessel will be able to handle a larger load on some routes, which is expected to generate additional revenues of approximately $175,000 per year in the first year of operation. These revenues are expected to grow at the rate of inflation. Revenues and operating costs from the new vessel will begin one year after it is delivered. The new vessel is estimated to have a useful service life of 20 years, but it will be depreciated for tax purposes according to the 7-year MACRS schedule. The new vessel is not expected to have any resale value at the end of its 20-year useful life. All revenues and costs (including depreciation) associated with the new vessel will begin one year after it is delivered. The Maracas is carried on RNI's books at a book value of only $100,000 and the book value of the spare parts is $40,000. The Maracas could probably be sold now "as is," together with its extensive inventory of spare parts, for $200,000. Mr. John stepped out on the foredeck of the Maracas as she chugged down the Cook Inlet. "A rusty old tub," he muttered, "but she's never let us down. I'll bet we could keep her going until next year while Racette & Sons are building her replacement. We could use up the spare parts ($40,000) to keep her going and we should even be able to sell or scrap her for book value when her replacement arrives."

RNI evaluates capital investments of this type using a 8.5% cost of capital. (This is a nominal, not real, rate.) RCI's tax rate is 35%.

Table 1:

Overhaul Expenditures Overhaul engine and generators $340,000

Replace radar and other electronic equipment 75,000

Repairs to hull and superstructure 310,000

Painting and other repairs 95,000 $820,000

Table 2: Depreciation (in %) for the 7-year Modified Accelerated Cost Recovery System
Year 1 14.29
Year 2 24.49
Year 3 17.49
Year 4 12.49
Year 5 8.93
Year 6 8.93
Year 7 8.93
Year 8 4.45

Table 3: Post-overhaul Operating Costs (Basic Overhaul)
Fuel $450,000
Labor and benefits 480,000
Maintenance 141,000
Other 110,000 $1,181,000

Table 4: Post-overhaul Operating Costs (Overhaul plus new engine & control system)

Fuel $400,000
Labor and benefits 405,000
Maintenance 105,000
Other 110,000 $1,020,000

Table 5: Operating Costs of New Vessel

Fuel $380,000
Labor and benefits 330,000
Maintenance 70,000
Other 105,000 $885,000

Calculate the equivalent annual costs of (a) overhauling and operating the Maracas for 12 more years (with and without the new engine and control system) and (b) buying and operating the proposed replacement vessel for 20 years. You should use the real discount rate for this analysis. Based on your answer, what should RNI do? Write one to two paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 3.