Mini Case 2 Capital Budgeting At Rio Negro Inc

Mini Case #2:
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, net of additional operating costs, 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 2:
Depreciation (in %) for the 7-year Modified Accelerated Cost Recovery System

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

Guidelines
for Case Analysis

The
following aids are permitted for this analysis:You
may use internet sources, books, all posted materials(including
Discussion Board Q&A), and your notes.

Any other aids are unauthorized and
their use constitutes a violation of academic integrity.This
includes face-to-face or electronic correspondence concerning the specific
details of the case with any other person that is not a member of your assigned
group, whether or not they have current or past affiliation with Texas A&M
Corpus Christi University.

The case is due on the date indicated on
the course schedule. Late papers may be accepted with a reasonable excuse, but
will be assessed a 20% grade reduction penalty. Cases should be typed in 12-
point font, double-spaced, with a minimum of 1 inch margins.

The case report
should be written according to the following format:

1. Introduction

1. Analysis

1. Conclusion

The
introduction sets the stage for the work to follow and should consist of a short
paragraph of the key problem(s) or issue(s) that your analysis addresses. The
analysis will constitute the bulk of the written presentation and will be a
direct response to the questions below. Use clear, concise, and complete
sentences. Do not use bullet points or numbered paragraphs. The conclusion
should be a short paragraph that summarizes the key points of the
analysis.

Your
report should not exceed five pages of double-spaced text with 1 inch
margins at the sides, top, and bottom of the page.This
does not include exhibits of your computations. You may submit one Excel
Spreadsheet that contains all your exhibits, clearly labeled, and
appropriately referenced in the text of your report.

Your
analysis of “Rio Negro, Inc.” should consist of answers to the questions below.
Do not write the questions verbatim in your report.Instead,
write a brief introductory statement that summarizes the question before you
proceed with your analysis.

4. Calculate
the present value of the proposed overhaul of the Maracas, with and
without the new engine and control system. Should RNI do the basic overhaul or
the expanded overhaul with the new engine and control system? For the moment,
ignore the option to purchase a new vessel (you will evaluate that option in
question 2 below).

Write a few paragraphs giving your
answer and clearly explaining your reasoning and computations; show detailed
computations in your Excel spreadsheet labeled Exhibit 1.

5. Calculate
the present value of buying and operating the new vessel. What, if any,
additional information would be useful to you in your analysis?

Write a few
paragraphs giving your answer and clearly explaining your reasoning and
computations; show detailed computations in your Excel spreadsheet labeled
Exhibit 2.

6. 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.

7. Why
is the equivalent annual cost method potentially useful in decision making in
this case? Why would you use the real discount rate to compute the EAC? What
problem(s) do you see with using the equivalent annual cost method to evaluate
RNI’s options?

One
to two paragraphs.

Your report is intended for the senior
management of Rio Negro, Inc., so be sure that you write in a professional
style that is easy to follow.