Question: Recognizing cash flows for capital investment projects. Johnny Buster owns Entertainment World, a place that combines fast food, innovative beverages, and arcade games. Worried about the shifting tastes of younger audiences, Johnny contemplates bringing in new simulators and virtual reality games to maintain customer interest. As part of this overhaul, Johnny is also looking at replacing his old Guitar Hero equipment with a Rock Band Pro machine. The Guitar Hero setup was purchased for $25,200 and has accumulated depreciation of $23,000, with a current trade-in value of $2,700. It currently costs Johnny $600 per month in utilities and another $5,000 a year in maintenance to run the Guitar Hero equipment. Johnny feels that the equipment could be kept in service for another 11 years, after which it would have no salvage value. The Rock Band Pro machine is more energy efficient and durable. It would reduce the utilities costs by 30% and cut the maintenance cost in half. The Rock Band Pro costs $49,000 and has an expected disposal value of $5,000 at the end of its useful life of 11 years. Johnny charges an entrance fee of $5 per hour for customers to play an unlimited number of games. He does not believe that replacing Guitar Hero with Rock Band Pro will have an impact on this charge or materially change the number of customers who will visit Entertainment World.

1. Johnny wants to evaluate the Rock Band Pro purchase using capital budgeting techniques. To help him, read through the problem and separate the cash flows into four groups:

(1) net initial investment cash flows,

(2) cash flow savings from operations,

(3) cash flows from terminal disposal of investment, and

(4) cash flows not relevant to the capital budgeting problem.

2. Assuming a tax rate of 40%, a required rate of return of 8%, and straight-line depreciation over the remaining useful life of equipment, should Johnny purchase Rock Band Pro?